How To Not Get Screwed By The Bond Bubble

by Rob Isbitts, Sungard Investment Research

To paraphrase an old Sean Connery/Roger Moore movie: bonds…high quality bonds. Bond funds, too. Bond funds, particularly those that invest in US Treasuries and other types of bonds at the low end of the risk spectrum, have been popular investments with individual investors for a long time.

Since a lot of those bond buyers are generally risk-averse, many of them likely moved cash out of money market funds to buy the bond funds, so there is likely a strong element of “reaching for yield” occurring there. That is, they were used to earning 6-7% on their Treasury Bonds not very long ago.

With rates on such bonds having been reduced to paltry levels, what did some of these investors do? Accept the lower level of return? In some cases, no. They decided it was more important to maintain their level of income yield than their level of bond quality. This has worked for years, but as the Federal Reserve continues to reduce the amount of US bonds they purchase to keep the market sufficiently greased, we think this insistence on achieving a target income yield at any cost (or risk) is going to come crashing down…hard. This doesn’t mean that bond prices will drop in one gigantic event. All it will take to scare the wits out of these investors, is to see something they have rarely seen as the bond market’s bubble ensued: negative performance numbers. Our guess is that just James Bond liked his drinks “shaken, not stirred,” the eventual outcome of this for bond investors will be BOTH shaken and stirred.

And while one never knows exactly what will happen next, we can try to intelligently and unemotionally size up the odds. Here is what I see:

1. Investors’ portfolios are WAY too heavily allocated to high quality bond funds.
2. That drastic over-weighting in such funds is often a product of fear, not prudence or an attempt to maintain a “healthy balance.”
3. Financial advisors realize this, even if their clients don’t.
4. Because they realize this, investors should be using this opportunity to re-educate themselves about the existence and benefits of low – correlation“defense first” growth alternatives to that high bond fund weighting.
5. Some financial advisors are putting off addressing this for two reasons:
   • Investors in high quality bond funds are doing well (as Treasury rates fall, the bond fund prices go up), and advisors think their client don’t want to sell what is working (and maybe the advisor doesn’t either).
   • The advisor does not have an alternative they are confident in.

Here are the keys to sidestepping the “bubble” conditions in bonds that so many market observers have, well, observed:

Start the education process NOW. Understand what you own.

Use history as your guide. The fact is, this generation of investors has not seen a secular decline in bond prices. Since the early 1980s, rates on U.S. Treasuries and other High-Quality bonds have generally moved downward.  This has created a false sense of comfort which must be unwound.

Start looking for ways to “thread the needle.” What do I mean by that? As noted earlier, you need to develop a strategy that accounts for falling bond prices.

Make greater use of low-volatility total return strategies as part of a bond replacement approach. In football, there is an old saw about running the ball, instead of passing it. Fans of the running game like to say that when you pass, three things can happen, and two of them are bad. That is, either the pass is incomplete and you gain nothing, or it is intercepted by the other team. Only a completed pass (one out of three possibilities) is a favorable outcome.

I will not debate the merits of passing versus running but I will analogize it to the matter at hand. If you own high-quality bonds or bond funds, there are three things that can happen:

1. Rates rise and your income return is uncompetitive
2. Stocks rise and your total return is uncompetitive
3. Rates stay low and stocks meander, while inflation stays tame, so your hunker-down investment is the safest and best-returning alternative

I am simply saying that the way to go about funding that “income” should be quite different from what the investor is used to.