Who’s Afraid of the Big Bad Bond Bubble?

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Wanderer

The Wanderer retired from his engineering job at a major Silicon Valley semiconductor company at the age of 33. He now travels the world, seeking out knowledge from other wealthy people, so that he can teach people how to become Financially Independent themselves.
Wanderer
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So today as I was sorting through the news and trying to find SOME topic that didn’t have the words “Trump” and “shithole” in it and I stumbled across this on CNN.

A sell-off in bonds could be “the Armageddon event for this year,” Naeem Aslam, chief market analyst for Think Markets UK, wrote in a report Tuesday.

A bond sell-off could be ‘Armageddon’ for the market, CNN.

Did you hear that? Armageddon, people! Nothing good is associated with the word “Armageddon.”

Repeat: Nothing.

And as usual when something that alarming is in the news, my inbox starts getting blasted with people asking me about it, and sure enough it happened. “Bond bubble? Armageddon? Should I sell off all my bonds? GAAAH!”

How Bond Pricing Works

Now, everyone generally understands how equity pricing works. If a company’s expected to do well, it’s stock price goes up, and if a company’s cocking things up, it’s stock price goes down. Up is good, down is bad.

But for bonds, it’s a little more complicated, and somewhat unintuitive, so first, let’s recap how bond pricing works.

Bonds are issued by the government of that country at an interest rate set by that country’s central bank. But how much that bond is actually worth is determined by the bond market, not the issuing government.

The bond market, meaning the combination of all bond traders out there, look at factors like the bond’s duration, interest rates, and the quality of the lender to decide how much they’d actually be willing to pay for that bond.

When a bond’s price goes up, that means its yield went down. This is because if a bond is paying a certain fixed percentage income (known as its coupon), and you ended up paying more for it than the last owner, than you’re effectively getting a lower yield since the underlying bond’s coupon hasn’t changed. Conversely, if a bond’s price goes down, its yield is going up since you were able to buy that bond for less money than the last guy.

So when the news is screaming about “YIELDS SHOOTING UP” that’s actually bad for existing holders of those bonds because it’s value is going down. Similarly, if “YIELDS ARE PLUMMETING,” that’s actually good for existing bondholders since their existing bonds just got more valuable.

Now, the factors that can’t change (like duration) are priced in at the time of issue. But the factors that can change (like interest rates) are the factors that can swing the bond market in one direction or another.

If central banks raise interest rates, this will cause bonds’ (and bond ETFs’) yields to rise as well, which pushes their price down. Conversely, if central banks lower interest rates, yields will fall and push bond prices up.

The Bond Bull Market

Ever since the Great Financial Crisis of 2007/2008, central banks have been dropping interest rates into the gutter in an attempt to stabilize and stimulate the economy.

Source: Federal Funds Rate 2007-2013 courtesy of MacroTrends

This has caused bonds to do what we would expect them to do in such an environment: go up.

Source: Yahoo Finance

This is what some bond traders refer to as the Bond Bull Market. But unlike an Equity Bull Market which is caused by economic growth, the Bond Bull Market has been caused, mainly, by falling interest rates.

Is a Bear Market Around the Corner?

So why it this a problem? Well, here’s why. Now that the economy is on the upswing, the Fed is raising interest rates.

Source: Federal Funds Rate 2007-2018 courtesy of MacroTrends

So if interest rates drop and cause bond prices to go up, surely the opposite must happen when interest rates climb back up, right? What goes up must come down.

Remember Why You Own Bonds in the First Place

Remember: You are not a pure bond investor. You should only be really worried about the gyrations of the bond market if that’s all you invest in, but we’re not pure bond investors here like Bill Gross. We’re investing in a balanced, diversified manner in accordance with the principles of Modern Portfolio Theory. And in Modern Portfolio Theory, the main driver of your performance are equities. That’s the part that’s powering your investment gains. And the primary reason you own bonds is to reduce your portfolio volatility. Bonds are anti-correlated to equities, meaning that when equity markets plummet, bonds rise, and when equity markets soar, bonds fall.

That’s exactly what’s happening now.

There’s a time and a place to be panicking about the bond market, and this isn’t one of them. A “bad” reason for the bond yields to be spiking would be:

  • Hyperinflation caused by a war
  • Collapse in the value the US Dollar
  • A hit to the credibility of the US government raising the possibility of a default on interest payments

None of those are even remotely true (well, maybe a hit to the credibility of the US government, but that’s another article).

The main reason that interest rates are creeping back up is because the economy is on solid footing. 200,000+ American jobs are being created each month and the US unemployment rate is the lowest it’s been in over 30 years.

Source: US unemployment rate courtesy of the Bureau of Labor Statistics

This is not a bad reason to be raising interest rates. If the main reason the Fed is raising interest rates is because the economy is too strong, whatever losses you take on the bond part of your portfolio will be swamped by the increases on your equity side.

Remember, the primary job of bonds in your portfolio is to reduce your portfolio volatility. If your situation has changed and you decide you can tolerate more volatility, that’s the time to reduce your bond allocation and replace it with equity. But if your volatility tolerance hasn’t changed and you’re just spooked by the prospect of bonds going down, please do yourself a favor and log out of your Questrade account.

That being said, there are a few things you can do to reduce the impact of rising interest rates while still keeping that nice buffering effect. And that will be the topic of next Wednesday’s post.

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Disclaimer: The views expressed is provided as a general source of information only and should not be considered to be personal investment advice or solicitation to buy or sell securities. Investors considering any investment should consult with their investment advisor to ensure that it is suitable for the investor’s circumstances and risk tolerance before making any investment decisions. The information contained in this blog was obtained from sources believe to be reliable, however, we cannot represent that it is accurate or complete.



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26 thoughts on “Who’s Afraid of the Big Bad Bond Bubble?”

  1. Well, this time I’m not so sure about that. Equity seems to be too high valued while bond prices are indeed going to fall as interest rises. So it seems we’re in a unique period of time where both investments will enter a bear at once. This rarely happens and it can scare anyone living off income already.
    I really hope I’m wrong but even Ben Graham predicted times like this in his book. Hold your hat folks! Though times coming

      1. There are precisely two times you encounter when investing:
        1) Everything is on fire and you’d be an idiot to invest now
        2) Everything’s way too overpriced and you’d be an idiot to invest now

        There has literally never been a time when the stock market has been fairly valued, with a good chance of upside, therefore now is a good time to invest. Never.

        Invest if you can, don’t time the market, and let it ride.

        1. 2009 was an obvious low point in investment chronology, when you study the strategies of Warren Buffet, and the like, you get some ideas around value, and quality. 90% trade on emotion’s, once you remove that you can see the value, or absence of value in any investment.

          Fairly valued? ya, whats your idea of Fair? Right now stocks are at all time highs, and we are in the longest bull run ever… I don’t look at where the market will go, I only care about, where it is now, and does my balance fit with my investment Horizons. Notice I said plural Horizons as I have short term and long term goals.

          Wanderer, what is your criteria as to a Value, or good investment? your opinions are always valued.

          cheers

  2. C’mon, how could Aerosmith still have been relevant in the late 90s (with their 1998 smash hit single “Don’t Wanna Miss a Thing”) if not for Armageddon? That’s a good thing, right?

    …right?

    okay, nevermind, I’ll just be over here rebalancing into VBTLX/BND.

  3. Yes, Bonds drop in value with a strong economy. My preference is to spit up the bond side of my balance with Can Bond Index/Can short term bond index/Canadian t-Bills/ and some cash in a High interest savings account. With the distributions, and even with the recent rate hikes, they drop very little, compared to equities.

  4. “If the main reason the Fed is raising interest rates is because the economy is too strong, whatever losses you take on the bond part of your portfolio will be swamped by the increases on your equity side.”

    That’s my thinking too. I don’t own bonds for return; I own bonds for the times when the stocks have horrible returns!

    I’ve moved about 10% of my assets to bonds over the past year and don’t mind if I miss out on the upside since the other 90% will do quite well if things keep going up.

    1. Justin , do you keep a cash cushion? If so can you tell me how big? I have invested amounts in RESP and other funds that are not part of my retirement funds. And cash for short term bill’s and expenses. I include these in my balance sheet. Some of this could also be used for
      an infusion into RRSP’s TFSA’s if the market tanks.

      cheers

      1. I keep about $35k in cash (which varies a lot as I accumulate, make tax moves, sell assets, buy stuff etc). $15k in CDs with minimal early cancellation penalties. Then $125k in bonds that are intermediate term.

        The $35k cash is plenty to get us through a year of living expenses, maybe 1.5-2 years if I add in dividends from the brokerage account ($8-10k/yr).

        It’s a highly individual choice. I feel good knowing I have several tiers of defense before I have to sell off stocks if the market is down. As in 4-5 years worth 🙂

        1. Thank you that is very valuable info. I have some cash for kids education, and to pay the next tax bill, I think if I extracted that, I would find I am at about a 70/30 Balance.

          cheers

  5. Thanks for the “steady hand” reminder! I look forward to reading your tips next Wednesday.

    In general, I agree with your overall approach: Stay the course with low-cost index investing and regular rebalancing. Most retail investors shoot themselves in the foot by trying to time the market, when they would be much better off just sticking with a simple and proven plan.

    1. What gives me comfort is that retail investors still don’t seem to have entered the stock market en masse yet. They’re all still scared of the stock market and investing in Bitcoin. Idiots.

  6. I’m not a huge bond fan (I prefer preferred shares), but your reasoning here is fairly sound.

    My personal opinion is that the Armageddon predictors miss a very important scenario — the global implications of the fed raising rates. Imagine for a moment that Japanese investors can borrow at 0.5% and then invest those proceeds into US Treasuries at 3%.

    Today that spread isn’t huge, but as the spread widens it creates huge returns for Japanese investors. Knowing that the Japanese gov. will maintain their currency and interest rate policy for the near future, this means very little risk in such a leverage bond play. This also will have the affect of keeping U.S. bond prices low, thus avoiding any bond dooms day scenario.

    In other words, I’m not worried!

      1. No, but this was a very common investing scenario for Japanese investors when the yield spreads were higher. In recent years with the Fed keeping rates low that trade dried up.

        If the fed keeps raising rates, it might come back again.

  7. I’m just curious of what you think of CoPower green bonds : https://copower.me/en/
    I’m on the process to buy some to incorporate into my bond allocations.

    These bonds are used to finance green energy project like solar panel. They need capital and they offer good returns (5%). Unfortunately the bonds are not rated…

  8. “Bonds are anti-correlated to equities, meaning that when equity markets plummet, bonds rise, and when equity markets soar, bonds fall.” This may be true historically, but it isn’t a law that will always work.

    Bond buyers do not consider the price of equities when deciding on the price for a bond, a falling stock market may increase demand for bonds, but rising interest rates will drive down prices too. There is real risk that especially long term government bonds could fall at the same time as a stock market decline if we see an unexpected rise in inflation in the short term. If you want to reduce the risk of loss of principal but own bonds, I think you have to give up some yield or add risk vs t-bills by moving to short-duration bonds (lower yield), or moving to bonds that aren’t as impacted by US Monetary policy like emerging markets (more risk) or high yield corporate (high risk).

  9. Yes bonds go down when interest rates rise, but by holding a bond ETF you mitigate this somewhat as the ETF should have laddered the bonds it holds which means that they are picking up the new, higher interest bonds as the old, lower interest ones expire. Added to this over time, as the ETF gets a higher percentage of the higher interest bonds, your dividend payouts should also increase.

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