The Bond Bubble Threat

When money flows into an asset class, prices inflate. With fixed income bonds, when prices rise, the yield declines. There is an inverse relationship between price and yield. In 2012, with European debt worries and a moribund Japanese yen, despite our downgrade, the U.S. dollar looked good by comparison. Money cascaded into U.S. Treasury securities, pushing up prices and depressing yields to the lowest levels in 60 years.

 The U.S. Federal Reserve Bank cooperated with the president in a massive expansion of the money supply. Through three bouts of quantitative easing and Operation Twist, interest rates have been depressed further. By buying billions in government debt, the Fed’s balance sheet has expanded to three times what it was before the 2008 financial crisis. Excess money creation has helped to fuel a stock market recovery and a rise in precious metals prices.

 Federal Reserve Chairman Ben Bernanke aims to keep interest rates low through at least 2014, pledging to suppress rates until unemployment hits 6.5 percent (or inflation clears 2.5 percent).

 To understand the implications of where we are, consider the history of the benchmark 10-year Treasury note. From 1900 to 2012 the average interest rate (yield) was 4.99% (often quoted as 5%). On January 18, 2013, the yield was 1.843%, well below the long-term average. The prime interest rate set by the Fed was 3.25%.

 In December 1980 at the end of the Jimmy Carter years, the prime interest rate peaked at 21.5%. At the time, 12% mortgages were considered a bargain! On September 30, 1981, the 10-year Treasury note hit a historical high of 15.84%!

 As the Reagan-Volcker recovery plan took hold, ending the stagflation trend of the 1970s, interest rates began a long, albeit bumpy, slide. On July 27 of last year, midst a tepid recovery, the yield on the 10-year Treasury note hit a record low of 1.394%. Remember, when interest rates go down, bond values rise. The descent from the stratospheric heights of over 15% to a low below 1.4% is unprecedented—it was the Mother of all Bond Bull Markets! And it is over!!!

 The lowest interest rates in decades and the highest bond prices reflect a classic bubble. What has happened since the low of 2012? Interest rates are creeping up. As noted above, on January 11 the 10-year rate was 1.843%. Rates have risen 44.9 basis points between the 2012 low and January 18. Yes, we are talking basis points (a basis point is one one-hundreds of one percent; one percent is 100 basis points). In the arcane world of bond math, that is a considerable move. Going forward, bonds will not be the safe refuge of recent years, and depending on the portfolio, an increasingly risky asset class.

 Reversion to the mean is a statistical fact. When the performance of an asset class runs substantially above or below a long-term average, the odds increase that at some point performance will move back toward the long-term average. It may take awhile for the interest rate on 10-year Treasury paper to re-approach 5%, but at some point, it will. As interest rates creep up, we are seeing a shift away from fixed debt instruments to variable rate paper, stocks, and various inflation hedges.

 Does this mean that you should abandon bonds? No, but everything depends on your specific situation, risk sensitivity, need for liquidity, and time frames. Selected corporate issues and emerging market bonds or low-duration bond funds may have a place within a conservative segment of your portfolio. Combined with FDIC-guaranteed deposits, a defensive bond portfolio may fit within a “bucket strategy” in designing a retirement cash flow strategy.

 Overcoming low interest rates and inflation plus taxes is a challenge for investors seeking a real net yield and portfolio growth. The bond bubble is about to upset the apple cart. Ignoring that fact may be hazardous to your wealth!

Lewis Walker is President of Walker Capital Management LLC and Walker Capital Advisory Services, Inc. Securities and certain advisory services offered through The Strategic Financial Alliance, Inc. (SFA).  Lewis Walker is a registered representatives of SFA which otherwise is unaffiliated with the Walker Capital Companies.