Bond Bubble? My Thoughts

Somebody posed a question regarding the bond market in the comments section of another post, so I thought I'd also clarify my thoughts on that matter in this post as well. There has been a lot of talk about a bond bubble and investors are wary and seeking alternative investments. Is that a wise course of action?

First, I think having the proper perspective on this issue is in order. Even in a doomsday scenario for bonds, the losses would pale into comparison to the potential losses and risk involved with investing in stocks. To further illustrate this point, check out the Growth of $10,000 chart of Vanguard Total Bond Market (VBMFX) courtesy of Morningstar since 1986.  The blue line is VBMFX, while the orange is the average intermediate term bond fund, and the green line is the BarCap US Aggregate Bond Index.

Growth of $10,000 since 1986
Source: Morningstar, Inc.
As you can see, it's been pretty smooth sailing and the volatility of such high-quality bonds is not that grave.  The most severe pullback was the big "bubble" of 1994, which produced a maximum loss of about 4%.   Google Finance reports VBMFX's worst three-month return as -3.00%.  While we certainly could have a historic pullback, previous measures of risk and volatility are indeed helpful.  (Note that the average intermediate-term bond fund pulled back nearly 9% in late 2008 after the MBS mess.  Yet another illustration as to why high-quality index funds are the way to go.  Clearly, too many bond managers took unnecessary risk in the effort to reach for yield).

Compare this total bond fund (blue line) to VFINX (Vanguard S&P 500; orange line) for even more perspective.

Growth of $10,000 since 1986
Source: Morningstar, Inc.
The decreases that were more apparent on the first graph have all but vanished when you compare it to the volatility of equities.  The bumps are nothing but small pebbles on the bond side.  So, while there is definitely risk involved in the bond market (I'm not saying it always goes up), it's important to have the understanding that the risk is still paltry compared to stocks even in this time of low interest rates.

Having said all that, I don't think investors' concerns about the bond market are without merit.  We live in unusual times and find ourselves in unusual circumstances - on the surface, the cautionary tales about bonds at this point in time do seem to have some valid points as we have somewhat "the perfect storm" of conditions that would signal a bond bear market.  

When interest rates rise (and they will undoubtedly rise unless we fall into a similar situation to Japan in the 1990s with low interest rates for a long period), your bond funds will take a hit in the short-term.  The longer duration of the fund, the bigger the hit.   However, as long as you hold your bond fund longer than the average duration, you should still end up ahead of the game and not have to really worry that you'll end up with a loss in the position over the long-term.  In this article from Vanguard, it is suggested that rising interest rates actually benefit investors over the long-term as long as you reinvest your interest income (Bonds and rates: The reality behind the headlines, February 2010).  They provide the following data:

Bond Fund Total Returns (annualized)
           Change in yield                            Year 1                 Year 3              Year 5                Year 7                  Year 10
Rising Interest Rates
Constant Interest Rates
Falling Interest Rates

Source: Vanguard

You can read their assumptions in the attached article.  Essentially, though, they conclude that while falling interest rates lead to better performance in the short-term, consistently rising rates are actually better for long-term performance (7+ years) assuming investors stay the course and reinvest interest income.

They conclude: "[I]f you're holding bond funds as part of your long-term asset allocation, a rise in rates probably shouldn't prompt you to make any changes. Indeed, you can benefit by sticking with the bond allocation that's right for you."

Here are two more Vanguard articles with similar messages and talking about the current bond environment: Should you beware of a bond bubble? (August 2010) and Risk of loss: Should investors shift from bonds because of the prospect of rising rates? (July 2010).  They have much the same message - don't fret about a bond bubble due to rising interest rates since over the long-term the small decrease will be more than compensated for.  They believe that individual investors are best served by maintaining their asset allocation and holding for the long-term, since reinvesting interest income will put you ahead. This is undoubtedly true. If you're a long-term investor, shouldn't you only be concerned with the long-term performance?  

I'll provide a contrarian viewpoint courtesy of the Finance Buff's blog entry You Should Still Beware of A Bond Bubble (August 2010).  He posits that if interest rates go up as expected, bond values will go down. It doesn't matter that the losses are small compared to the potential losses in equities - it's still a loss.  Shouldn't investors actively avoid such obvious potential losses?  And while it's true that reinvesting interest income in your bond funds over the long-term will benefit you in a rising interest rate environment, the Finance Buff argues that the returns would have been even better if you sidestepped the short-term rise in interest rates and invested in bonds at a slightly later time.

I think both perspectives have a valid point.  Interest rates are going to go up; it's just a matter of when. When that occurs, your bond fund's NAV will take a hit. The longer-term duration funds will take a larger hit than the shorter-term ones. Over the long-term, this temporary hit will be compensated by reinvesting interest income at higher rates and you'll end up ahead if you stay the course.

Bonds are held as part of an individual's portfolio to moderate volatility and increase diversification.  Thus, you shouldn't completely abandon your bond holdings nor switch to equities with that allocation under any circumstance. Nevertheless, if you are uncomfortable with potential for short-term losses in the bond portion of your portfolio, I think there are a couple viable alternatives. 

First, you may elect to shorten the duration of your bond holdings.  Instead of selecting a Total Bond Market Index fund (VBMFX has an average duration of 4.7 yrs), choose a short-term index like VBISX (2.6 yrs). This will cut the potential for short-term losses in about half.  (Obviously this comes at the expense of expected returns. There is no free lunch.)

For more information on how bond prices interact with interest rates, see this bogleheads article: Bonds: Advanced Topics - Duration

"For example, a bond with a duration value of 5 years would be expected to lose 5% of its market value if interest rates rose by 1% (100 basis points)."  Thus, while the total bond fund might lose 5% of its value, the short-term index would lose only 2.5%.  These figures are not exact and for illustrative purposes as there are other factors that can affect such an outcome.

Secondly, you may choose to use CDs as an alternative to your bond position. This is what the Finance Buff suggests.  You could also use a combination of short-term bonds and CDs.  I think that's a reasonable course of action.   Or even all three positions if it's a significant sum of money - keep a total bond, short term, and CDs.  Spread your money across the strategies.

In the end, while the above two options will probably reduce the chance for a significant short-term pullback and you'll be less affected by the potential "bubble," you will not be able to time it perfectly as to when to get back in the bond market. Thus, you'll miss some opportunity and whether you come out ahead (when compared to simply sticking with your previous asset allocation to total bond) will largely be determined by luck.

Thus, if you're simply interested in your long-term performance, it probably makes the most sense to stick to your asset allocation plan. If you're concerned about short-term volatility in the bond market and have discipline to jump back in, it's reasonable to shift to shorter durations and/or CDs and then re-assess this position as time goes on. Will you come out ahead of the other strategy? Maybe.  Will your short-term volatility be decreased? Yes.

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