Bond Bubble to Burst? Take Shelter?

September 17, 2010 | By Steven DiGregorio

For those that are in retirement already or approaching retirement soon, the prospect of a bursting bond bubble and another hit to your personal retirement assets is enough to make you head for the hills!  The past decade has proven to be quite volatile given two “stock bubbles”, a “real estate bubble” and a “derivatives bubble”.  Now, with so much money flowing into Treasuries and interest rates so low, many are wondering if the next great event will be a “bond bubble” bursting!

While investors certainly need to be cautious and alert to the risk of investing in bonds today, do not to be misled by the media hype of another bubble about to burst.  It would not be recommended for investors to avoid bonds entirely due to the “inflated” fears.  While bond prices are relatively high and interest rates inordinately low, that is largely a reflection of the outlook for continued sluggish economic growth and restrained inflation in the near future.

Eventually, I believe that outlook will change and the Fed’s easy-money policy, budget deficits and spending in Washington, D.C. will have the potential to reignite inflation at some point down the road. But even if that eventually happens, it could take years for expectations and bond yields to reflect that scenario.

The phrase “bond bubble” conjures up visions of a meltdown the likes of stock and real estate markets’ free fall declines.  But bonds have never had such a devastating collapse. Indeed, the worst 12-month loss for the U.S. bond market was merely a fraction of recent equity losses.  Interestingly, although the values of bonds and bond funds do traditionally take a hit when interest rates rise, investors who own a bond fund or diversified portfolio of bonds should see their returns rise over time assuming they reinvest interest payments in new bonds paying the higher rates.

So what’s an investor to do?

The answer comes down to weighing the alternatives.  You could easily avoid a possible bond bubble by selling out of bonds. But then where would you put the proceeds? Stocks or CDs?

  • Increasing your exposure to the equity markets could leave you at even greater risk than holding onto your bonds since stock downturns are generally far steeper than anything you’re likely to experience in bonds.
  • Some people see safety in gold. If you mean safety in the sense of stability, it’s an illusion. Gold prices jump around like stock prices.
  • You could sell your bond holdings, put the proceeds in cash equivalents like short-term CDs, money-market accounts or money funds and then get back into bonds after the bond bubble bursts (if that really happens) or the concern about a bubble passes. But in the meantime you could be earning a measly 1% or less — and you would have to have the luck of timing to get back into the bond market.

The fact is this, although it’s easy to think that with interest rates so low they have nowhere to go but up, no one really knows what the future of rates will be, let alone the timing of any movements. Given that uncertainty and the lack of decent alternatives, you could consider maintaining your position in bonds but take reasonable precautions to limit the downside should interest rates rise.

What precautions am I referring to?

  • Make sure the bond positions in your portfolio are well diversified. While Treasury securities offer the most protection from default, they tend to be more sensitive to interest rate changes. So you might want to consider investing in a portfolio that contains both Treasurys to limit credit, or default, risk as well as high-quality corporate bonds that, because of their generally higher coupon rates and yields, won’t be hit quite as hard as Treasurys if rates rise.
  • Stick to the short to intermediate end of the maturity spectrum, as bonds with shorter maturities tend to lose less value in periods of rising rates.  This is no silver bullet because with interest rates so low it’s very possible that rates on short-term issues could climb more than those on long-term bonds. Still, over longer periods short- and intermediate-term issues are likely to provide smoother returns and more protection from rising rates.  You could build a portfolio of short to intermediate term bonds on your own or more simply be reinvesting dividends in a broadly diversified bond fund that holds both Treasurys and high-quality corporates.  In fact, you can get the entire U.S. taxable bond market in a single fund with a total bond market index fund. That would put you squarely in the intermediate-term range.  If you want to tilt your holdings more toward the shorter-end, you could invest some of your money in a short-term bond index fund as well.
  • You could devote a portion of your bond money to TIPS, or Treasury Inflation-Protected Securities  Two concerns though: Although TIPS give you a guaranteed “real” rate of return above inflation, that real rate has been quite thin lately as investors have been less concerned about inflation.
  • Consider high-yield or junk bonds, but remember, they’re always riskier than investment-grade issues. And they could get hit especially hard if investors become convinced the U.S. economy is headed for a dreaded double-dip recession. So if you do decide to branch out, think of them as long-term components of a portfolio that you will periodically re-balance.

The bottom line though, is that timing the bond market makes about as much sense as timing the stock market…, none at all.  So despite the cries that the bond market is about to blow, I contend it would be a mistake to pull entirely out of bonds.  A more prudent way to go is to make sure your bond holdings are sufficiently diversified so your portfolio won’t be devastated should rates rise, and that it will also be in a position to benefit over time from higher rates.

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The author of this blog, Steven M DiGregorio is President of Compass Asset Management Group, LLC and an Investment Advisor Representative with Spire Wealth Management, LLC a Federally Registered Investment Advisory Firm.  Securities offered through an affilliated company Spire Securities, LLC a Registered Broker/Dealer and member FINRA/SIPC.

Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client’s investment portfolio. No client or prospective client should assume that any information presented and/or made available on this site serves as the receipt of, or a substitute for, personalized individual advice from the adviser or any other investment professional.

Tags: bond bubble, bonds, Exchange Traded Funds, financial planning, high yield, investing, investment strategies, investments, mutual funds, portfolio, preferred stocks, retirement, retirement income, retirement plan, Retirement Planning, stocks, TIPs, Treasuries

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STEVEN M DIGREGORIO is President of Compass Asset Management Group, LLC and an Investment Advisor Representative with Spire Wealth Management, LLC.
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