The Great Bond Bubble Is Now! What's Next…
It's Not About Market Timing: It's About Business Common Sense
Key Ideas
- Discover how “safe portfolios” could be the riskiest of all.
- Explains why it is just simple risk vs. reward analysis based on valuations.
- Reveals the one action I'm taking to protect my portfolio.
What does the bond market today have in common with the stock market in 1998-2000 and the real estate market in 2006-2007?
They were all in ridiculous bubbles that ended very badly for investors.
This may sound like a bold prediction, but in fact, it's not. It's simple risk vs. reward analysis based on valuations.
This simple mathematical analysis has saved my portfolio twice from past bubbles and can save your portfolio this time.
(Editor's Note – I published this post in March 2013 and have not edited it since for transparency. Bond returns since that date speak to the integrity of the analysis that follows.)
Let's explore how it works…
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Treasury Bonds Bubble Analysis
Interest rates peaked back in September 1981 and have been falling ever since to reach today's extreme lows.
According to O'Shaughnessy Asset Management, 2013 provides the most difficult environment for generating income in 140 years. Since 1871, there has never been a lower yield period in history – not even close.
The average historical yield on a 60% equity / 40% bond portfolio has averaged 4.36%, and is now at an all time low of just 2.0%. Clearly, we are in extreme territory for low interest rates.
In fact, research on 30 year bond rates going all the way back to before the Civil War (1790) shows the United States has never been able to borrow long-term capital more cheaply than it can right now. Unbelievable!
Further proving how extreme our current point in history really is, Timely Portfolio's did a fascinating study on 10 Year U.S. Treasuries (constant maturity similar to IEF) evaluating what would happen if interest rates went to their theoretical minimum – zero.
Are you ready – drum roll please – a paltry 17% gain. Shocking, but true.
That means that if interest rates went as far as they could theoretically go on the downside, the entire upside left on 10 Year Treasuries is a mere 17%.
That's not much considering it's the mathematical extreme case limit for how far it could go. Your actual returns would depend on how long it took to reach this limit.
For example, Market Sci blog showed that if it took 4 years to reach zero percent interest rates, then the annualized return would be just 5%, and the total return would be 21.6%.
This may not sound too bad until you realize that 0% yield is not very likely. Given that Japan's record low yield for their 10 Year Note was .47%, it's interesting to note the maximum upside is reduced to a mere 13.8%.
If it takes 4 years to get there, your annual return is just 4.1% with a total return of 17.6% – before inflation! If you net out inflation, the real return is minuscule at best.
The implication is clear – the upside potential in bonds makes no sense compared to the downside risk.
The problem is bond prices move inversely to interest rates, and interest rates are approaching their theoretical floor. In other words, as rates decline, bonds rise in value. As rates rise, bonds lose value.
There is little room left for interest rates to fall, and tons of room for rates to rise, creating an unfavorable risk/reward ratio.
This problem is further exacerbated by the fact that current low interest rates would cause a modest rise in rates to cause disproportionately large losses that could dwarf any income received in the interim.
For example, as of this writing, a mere 1% rise in interest rates on the Treasury long bond should equate to a roughly 20% price decline, wiping out 7 years of income at current interest rates.
Do you think it's reasonable to expect a mere 1% increase in interest rates from these historically low levels over the next seven years as the above example illustrates? After all, far worse has occurred in the past when markets were less volatile.
For example, the 30 year Treasury yield rose 240 basis points in just 9 months back in 1994. Just imagine what a 2 – 3% rise (or more) would mean to investor portfolios given the above example.
Why the Bond Bubble Is More Important Than Previous Bubbles
This is critically important because fixed income's traditional position within asset allocation is as a “safe investment“.
In fact, we have entered one of those rare points in history where the risk/reward analysis on bonds could conceivably be more dangerous than equities, because the historically low coupon implies historically unprecedented volatility and downside price risk.
In other words, capital loss risk to bonds is highest when starting yields are lowest. Given that yields are at all time historical lows, many historical benchmarks for capital losses in bonds are unrealistically conservative. The future could easily be far worse than the past.
For example, according to Welton Investment Corporation the deepest (-15.3%) and longest (8+ years) Aaa corporate bond drawdown occurred from 1954-1963 because of a tiny 1.8% increase in interest rates – a hiccup by today's volatile standards. The reason is because the starting yield in 1954 was an equally tiny 2.85%.
In other words, the drawdown severity and duration isn't determined exclusively by the magnitude of the interest rate rise. It's determined by the relationship of the interest rate increase compared to the starting yield. Today's record low yields imply historically high risk of capital loss.
For example, Welton also analyzed what could happen to Aaa corporate bonds under different interest rate increase scenarios:
- A 6% increase spread over 5 years would result in a 36.2% drawdown and a 6.4% annual loss.
- A 4% increase in just 1 year would result in a whopping 34.8% drawdown and a 34.8% annual loss.
- Even a modest increase spread over many years could cause zero return (or worse) for more than a decade.
These losses may not look horrific by equity market standards, but it's important to note the money parked in top quality bonds is considered “low or no risk”. That is clearly no longer the case, and it has serious implications for traditional asset allocation models.
Some might argue that if you hold the bonds to maturity then price risk is only a temporary problem, but that's a dangerous half-truth.
Today's investors frequently hold their bonds in diversified pools of mutual funds and ETF's, giving up any ability ride out the downturn and hold a specific bond to maturity. The losses can become permanent.
Whether you think interest rates will rise or not is irrelevant. The point is the downside risk of loss is high in what many investors consider to be their safest investments, and they are getting paid paltry returns to accept that risk. The risk vs. reward ratio is absurd. It makes no sense.
In short, the risk to fixed income portfolios is extraordinary right now.
Limitations; Caveats
Given the unfavorable risk/reward ratio, what should you do as an investor?
That depends on many factors including your investment goals, time horizon, specific portfolio composition (duration, quality, etc.) and how much interest rates actually rise.
Of course, I don't have a crystal ball and have no clue when and to what degree interest rates will rise. I just know it will eventually happen, and the downside risk when it occurs doesn't justify the return being offered to accept that risk.
That is the only relevant point. The math is unequivocal on this fact.
The only questions remaining are timing and severity – both are complete unknowns.
What we do know is eventually, investors will demand greater return to accept the risk associated with lending their money. As nations become increasingly in debt, how many more short-term fiscal manipulations can be applied to keep interest rates artificially low?
I don't know (and neither does anyone else).
What we do know is a turn of the tide in interest rates is merely a question of when – not if.
And yes, I'm fully aware that naysayers have been saying the same about Japan for a very long time and been completely wrong. True! I'm the first to admit this analysis says absolutely nothing about timing – a critically important fact.
The bubble could continue for years before turning, but that doesn't change the mathematical reality that it's clearly a bubble — risk to reward analysis makes no economic sense.
Would you lend to the U.S. Government for 5 years for an 88 basis point return? Nobody in their right minds should risk substantial downside losses for a maximum potential upside gain close to zero (or worse) net of inflation.
What Can You Do to Protect Yourself?
I'm not in the investment forecasting business.
I rarely write posts like this because forecasting financial markets is a fools game that has no place in sound investing. The future is unknowable and anybody who plays in forecasting the market is destined for humility.
What I'm sharing with you here isn't a forecast. It's a risk/reward analysis of a broad market sector based on mathematics.
There are rare times when valuations in specific markets reach such absurd levels that the risk vs. reward ratio allows you to make investment decisions without any specific forecast.
I've done this twice in the past (publicly), and I'm doing it a third time right now.
- How did I know to sell all my investment real estate in 2006 right before the market top?
- How did I know to sell my investment management company in 1997 and remove traditional equity allocations from my portfolio 3 years too early before the big top in stocks?
Actually, I never knew either market was at or near a top. That would be a forecast.
All I knew was the risk/reward analysis was extraordinarily unfavorable to where participating in that market no longer made sense. It was based entirely on business common sense and required no forecast.
I want to be clear that I had no idea when the actual market tops would occur in the past or how they would come unwound, and the same is true with the bond bubble today.
For example, when I sold my investment real estate holdings in 2006, the only thing I knew was my $600/month apartment tenants who didn't qualify to rent from me were getting 30 year mortgages on $300,000 homes.
I knew their credit and rent payment histories as their landlord, and I was 100% certain they didn't qualify under any reasonable lending standards – yet they somehow got loans. (Of course, we found out after that fact there was massive lending fraud.)
I also saw the real estate investment deals my financial coaching clients were examining. Valuations got so absurd near the top in 2006 that deals were transacting where it was literally impossible to make money from operating the property.
Even if you had zero vacancy, no maintenance costs, no turnover costs, and none of your expenses ever increased, the property would still be cash flow negative.
The only possible way to profit from ownership was if a greater fool came along and paid an even stupider price for the property than was being asked at the time. It was a recipe for disaster.
It doesn't take a rocket scientist to see the risk to real estate when the absolute lowest credit quality buyers are already fully invested in the market, and prices are so high they make no economic sense using absurdly optimistic assumptions.
The balance of supply/demand had to tilt to the downside. It was business common sense.
What I didn't know was when or how much real estate would decline. The fact that selling all my real estate by the end of 2006 was nearly perfect timing was actually total luck.
Truly, I had no idea.
The real estate markets could have remained overvalued for years and gone to even more unfathomable extremes. I didn't know where and when the bubble would end. I just knew it was a bubble and the valuations made no sense.
I sold my properties for more than two times as much as I was willing to pay for them, paid the taxes on the gains, and never looked back.
Similarly, when the stock market bubbled in the late 1990's, I eliminated all of my traditional equity allocation in my portfolio, and sold my investment management company by the end of 1997. In this case my timing was way too early.
The markets continued to rise relentlessly, going from ridiculously overvalued to unbelievably overvalued before the final top in 2000. Again, it's just business common sense that when the entire NASDAQ index is selling for more than 200 times earnings at the top, it can only end badly.
It was just a question of when – not if. The valuation was unsupportable. It was business common sense.
Everybody and their mother wanted to get rich in stocks back then. Every coaching client wanted hot stock tips.
Heck, I even had a client end our relationship when I started teaching him how to understand the risk inherent in his 100% tech stock portfolio. He was blind to the message and lost most of his net worth in the downturn that followed.
The psychology was absolutely frothy, and amazingly, it continued that way for years, creating the most overvalued stock market in U.S. history.
I had no idea on the timing for the bubble burst, and in this case, I was way too early. Ultimately, the position was vindicated by the massive decline that followed, but I want to be clear that this type of analysis tells you absolutely nothing about timing – only ultimate outcomes.
The markets can remain irrational for far longer than you can remain solvent, so be careful what you conclude from this analysis.
And that brings us to today's bubble du jour – the bond market. I have absolutely no clue when the final top will occur. It could finish this week or continue on its merry death march for a few more years.
It's impossible to know because nobody can predict the future… least of all, me.
With that said, what you know from the above analysis is supply/demand is now grossly out of whack. According to Fidelity, more than $1.1 trillion was allocated into bond mutual funds and ETF's since 2007, while equity funds received just $33 billion – an astonishing 33 times more to bonds than stocks.
Bank of America provided similar numbers, showing U.S. investors pulled $600 billion dollars from U.S. equity funds while simultaneously adding $800 billion to bond funds – a massive, one-sided tilt in allocation.
Research demonstrates that extreme, multi-year capital inflows into an asset category has historically lead to unfavorable risk/reward ratios in subsequent years as reversion to the mean takes hold.
According to Reuters, even the biggest names in bond management (PIMCO, Loomis, DoubleLine) are making business moves into equity funds and diversifying their businesses. The writing is on the wall.
Bottom line is valuations make no sense in the interest rate market. Would you loan money for 30 years at 3% to a government that is so deeply in debt that it's mathematically impossible to repay its debt? Of course not! It's insane. Completely insane.
Yet, fortunes are traded every day on that exact premise and people have major chunks of their retirement savings invested accordingly. Hopefully you will be wiser. Caveat emptor.
Appropriate Investment Strategy
Only you can decide what the appropriate investment strategy is for your portfolio.
This is an educational article and does not offer personal investment advice.
With that disclosure in place, you probably want to know what I'm doing with my own money given this information.
The answer is I will do the same thing I did before the stock market bubble burst and the real estate bubble burst: I exit the market.
Because markets can stay insane far longer than you can remain solvent, I never short a market based on risk/reward analysis. It makes sense for my investing to remove risk by eliminating or reducing market exposure based on unfavorable risk/reward ratios.
I'm willing to accept the risk of leaving the last few breadcrumbs on the table and being temporarily wrong for years in exchange for giving up the risk of being invested during the highest risk periods when mathematical expectation is unfavorable.
Others may view their investment situation differently and be equally correct. For example, U.S. Treasury bonds are one of the few asset classes that have maintained low to negative correlation with equities in recent years, providing a valuable portfolio diversifier that has substantially reduced volatility in the past.
However, as I teach here and here, investing done right is about building a portfolio of favorable risk/reward ratios resulting in positive mathematical expectation.
This is the math that governs how money compounds and it's inviolable. Mathematical expectation trumps all other investment considerations, and bonds show limited upside potential with strong downside risk.
You are now armed with the necessary knowledge. The choice is yours.
What do you think about this latest bubble situation? Tell me in the comments below…
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Really like this, particularly that you are so upfront about telling us what you don’t and didn’t know 😀
I’ve read similar analysis elsewhere over recent days. I’m happy I have no exposure to the bond market.
I’m really enjoying reading here, and I feel I’m learning a lot. Thanks.
@davidwallace1000 Thanks David! Yes, it is critically important when investing to know the limits to your knowledge and how to work with those lmiitations. The future is forever unknowable. One must accept risk into the future given this limitation. It is an amazing process.
Great article and thank you for sharing, Todd! One main take away is ‘herd mentality’, i.e. pre stock market bubble a dentist was making more money day trading than practicing dentistry. Of course everyone else will look to do the same.
Equity markets have been volatile and the highest demographic (people with money) are baby boomers. They have reason to be concerned about their retirement picture, especially ones without a pension. Strong, highly rated corp. bonds and even treasuries seem to be a rational investment choice because of principal protection (assuming held to maturity). And yes, there is the half truth story here b/c bonds are not exactly readily available to retail consumers. So, bond funds and ETFs would likely be the alternative and there is no principal protection.
Given the data, we have seen a 30 year decline in interest rates. So, yes it is a matter of when – not if. Thank you again for posting this timely piece. All the best, save4urfuture
@bp019j save4urfuture Thanks Tim. Yes, it is amazing to watch these rolling bubbles created by government manipulation in the markets. They keep messing up the normal economic signals that would prevent such occurrences.
Thanks for the excellent, timely post Todd. I appreciate your analysis, and your sharing of valuable experiences from 1997 and 2006. An important takeaway is that, while we might be reasonably certain about risk/reward (based on valuations), we can’t know about timing. I think that would make me loathe to ever completely sell out of a given asset class.
And there is an important follow-up question that anybody contemplating action will have to face: where to put the money, if not in bonds? Many of the major asset classes are experiencing price inflation now. Other trusted advisers think equities are high. Cash carries inflation risk. Perhaps the needle is swinging back to real estate? I prefer a diversified portfolio to trying to answer these questions. Though I definitely pay attention to trusted voices like yours when thinking about asset allocation.
Thanks again for tackling a difficult and dicey subject and taking a clear position!
@DarrowK Thanks Darrow! Your second question about investment alternatives is answered above in the reply to JWinston.
Your first question is interesting because being completely out of an asset class that is dramatically overvalued to the point of being in rarefied bubble territory actually makes me comfortable – the opposite of the effect you are expressing.
I’ve spent a lot of time studying the relationship of extreme valuations and subsequent market returns and the data is absolutely clear. It is one of the most robust and consistent market relationships you will work with. It holds up across asset classes and international data (as well as domestic).
I’m way more uncomfortable accepting the risk of being long during extreme overvaluation and greatly prefer the risk of missing whatever paltry returns might remain on the table by side-stepping the market entirely.
Again, these situation are rare. But when they occur the math is quite clear on at least one appropriate action.
Great post. What do you think of Vanguard’s new Total International Bond Index Fund? Do you see Vanguard’s plan to include this International Bond Index Fund in its all-in-one funds (in a 80/20 US/International split) as another example of your premise?
https://personal.vanguard.com/us/insights/article/fund-announcement-02062013
@thesimplewalker I don’t like to comment on specific investment vehicles, but I will say that fund companies are savvy marketing organizations and will typically launch products into the highest demand for that product. In other words, you will see a lot of technology funds launch into the height of a technology bubble and the same is true for bonds.
@Financialmentor Good point. Generally, do you think international bond funds have the same current risk as US bond funds?
@thesimplewalker @Financialmentor No opinion. I haven’t done the analysis.
Todd, thanks for sharing. I liked your analysis. Do you put high yield bond funds in the same risk category?
@loicb Yes. All fixed income where capital gain or loss is inverse to changes in interest rates is included. High yield has some other investment characteristics to pay attention to (quality of economy related to risk of default as an example), but they are still interest sensitive instruments.
Todd:
Thank you for the great article. You put analysis and math to the thoughts that I have been having about the bond market. I try to keep a balanced portfolio, so I have quite a bit of money in bond funds of various types. I assume many others do too. If you exit the bond markets, what do you substitute for the conservative portion of the portfolio? All I can think of is cash which earns almost nothing. Thanks again!
@jwinston I’m not a fan of our government policy to wage war on savers to pad the bottom line of banking profits. As you correctly point out, there aren’t many good choices left for traditional asset allocators. Some people are finding safety in real estate because that bubble already burst providing reasonable valuations in selected parts of the country. For my mother, I chose short term CD’s paying barely above zero simply because I know she will be fine with zero return but can’t survive a significant negative return. Others have chosen international securities that are reasonably valued. For my own investing, I’ve chosen a different model entirely by “rowing instead of sailing” using the words of Ed Easterling. In other words, I don’t like the playing field so I chose a different game. In short, there are no good answers. It is a very difficult time for traditional asset allocation models given extreme valuations in both bonds and stocks.
@Financialmentor @jwinston Todd, how about having your Bond part of the portfolio as IBonds? The downside risk is minimal and if inflation kicks in then you can get the benefit? Or Am I missing something?
@Financialmentor @jwinston Todd, how about having your Bond part of the portfolio as IBonds? The downside risk is minimal and if inflation kicks in then you can get the benefit? Or Am I missing something?
Todd,
Thanks for being candid about your ability to “predict the future.”
I will not be buying any U.S. Treasuries for the foreseable future. Unfunded liabilities in the U.S. will never be repaid.
Your article about your investing demonstrates a couple of things the herd/retail investor does not understand:
1. You do not always have to be invested; you can take profits and sit on the sidelines.
2. You should invest based on sound business principles and valuations (I never really understand why comps are used in real estate; like you said it’s based on the greater fool theory).
Thanks for sharing the article.
Will
@Invest2013 Funny you should catch the greater fool theory comment. All assets have 3 methods of valuation, and “comparable sales” (which is the basis of residential real estate appraisal) has the lowest business value because it is nothing more than the great fool theory institutionalized. It really is quite strange to understand that it is industry standard practice. I also like to use income analysis and replacement cost as is common practice on the commercial side of the industry.
Great article Todd!
It’s refreshing to find a financial advisor who acknowledges the fact that forecasting financial markets is at best a waste of time and bases his decisions on risk/reward.
The 2 examples you gave us based on your personnal experiences are priceless.
Having said that, I’m not really sure I agree with your rule “I never short a market based on risk/reward analysis”. Could you elaborate on that? I understand that if you use buy put options you could be bleeding for years or even decaces (Japanese bubble) until you become insovlent. Fine. But what if you invested in reverse ETFs to put yourself in a position to take advantage of the low downside/high upside potential of the trade? Or am I missing some crucial technical element in my analysis?
Thanks again.
@NoDeliveryPizza The math on the short side and the investment instruments used are both very different. First off, the short side has limited gains potential as they only fall (rise) so far. Second, investment instruments on the short side are synthetic or derivatives creating widely different risk profiles. For example, many of the short funds track daily price volatility causing basis risk to the longer term trends you are trying to capture. The simpler answer is the short side is not a mirror image of the long side. Creating a positive mathematical expectation on the short side is very difficult to achieve.
@Financialmentor Thanks for the explantation. I’ll be cautious. The thing is it’s frustrating not to be able to short on such a good risk/reward profile in a more “straightforward” way (e.g. less synthetic).
Todd,
I always have enjoyed the priviledge of you letting me in on your thinking. This bond article is no different. You succintly lay out the risks involved in being a personal investor in the bond market, especially in bond mutual funds and ETFs.
The thing that “scares” me the most is the implication of rising interest rates and what that implies about the governmental interest payments that we are barely able to keep up with at these low interest rates. Its almost as if the US Treasury/Fed will do almost anything to keep rates low until we get a robust economy where taxes,etc. can support a bigger debt level. And that is just not happening today.
I glad I’m not a pessimist. I could come up with some very bad scenarios as to what might happen.
Bill
@wbarack Hey Bill, great to hear from you! Yes, there are many ideas intentionally omitted from this article to keep it on track and focused. For example, it is my understanding the Fed will be buying (monetizing) 90% of the new issuance of Treasury and mortgage securities in 2013 leaving only 10% added to float. It is the miserable economy that allows them to get away with that maneuver without causing massive inflation; yet, it is the very same behavior that causes everyone to see this is as a false economy. They are walking a tightrope that can fall miserably to either side (deflation or inflation) and the results will likely be dramatic when it occurs. The only problem is I really can’t tell which will happen first although the ultimate outcome (inflation) is baked in the cake. The problem is the massive risk of deflation in the interim. Very difficult times, indeed.
Excellent and truthful analysis. Indeed, the bond bubble will end badly.
@mh2007 Thanks for the Kudos. Only time will tell how it all comes out. I was surprised by the extent of the real estate decline so we will see when and how this one develops.
Hi, Todd.
When you said you’re exiting the market, did you just mean the bond market or both the bond market AND the equity market? Do you suggest just staying in cash on the sidelines?
Thanks
@thaddie This article only addresses the United States bond market in the context of the current Federal Reserve policy induced bubble as of 2013. I can’t tell you what to specifically do with your own money because that is investment advice and everyone’s personal investment situation is unique. You will have to decide what is an appropriate investment strategy for your situation or work with your investment adviser to do the same.
Hi Todd,
Great analysis as usual! I appreciate your honesty about not being able to predict future events as if you had a crystal ball. I read/listen to “investment gurus” who claim to have the “secret knowledge”. Phooey! Thanks for making the Bond Bubble easier to understand. Risk/Reward analysis is something I would never be able to ascertain on my own. Great insight!
Aloha, ellen
@mrsmelon Thanks Ellen! Yes, not many people understand risk/reward analysis and mathematical expectancy, yet it is the core of sound investing. Thanks for joining the conversation and sharing your thoughts. I’m glad you got good value from the article.
Great article, Todd. I’m happy to hear the 52 week course will be starting up soon, thank you!
Warm Wishes,
Sabrina
@sgottlieb Glad you liked it Sabrina. Thanks for sharing your thoughts.
Another great article Todd. I am a big fan & I am in total agreement. What are your thoughts on very short term bond funds with very low durations? Many people have a large percentage of their net worth in their companies 401(k) plans & you have to invest the money somewhere. I am also a big fan of John Hussman & he currently is very cautious on the stock market for a number of reasons. These are truly interesting times for sure……again great article & thanks for your time…..Bryan.
@BryMc If “interesting” equals “difficult” for conventional asset allocation then I agree with you.
@Financialmentor
Yes….very difficult. Like I said in my original post, people with large 401(k) balances with traditional asset classes offered are possibly in a no win situation. I know that it will be less severe the lower the duration……is there a duration where the increase in interest rates would at least offset the unrealized loss in the price of the bond fund?
@Financialmentor
After posting duration question…..thought through it…..the answer I believe is 1 (one) — right?
Is it likely that the bursting of the bond market lead to a stock market crash or only the bond market is likely to be affected
narayankplI do not believe in market timing. My thought is the stock market is inflated due to leverage and cheap credit. We can’t predict the future, however we can prepare for it. Happy investing.
momentumrisk narayankpl Would you call stepping out of the market now adequate preparation
narayankpl momentumrisk Not sure, that is for you to decide. I am not providing investment advice, nor should you consider my comments as investment advice. You would need to consult with your investment advisor.
See Todd’s comment below to thaddie
Hi Todd and thanks for sharing your thoughts on the bond bubble. As others have said, I appreciate that you “walk the talk” and don’t try to predict the timing on an investment activity. Still, here are some facts to consider when thinking about getting in or out of the U.S. bond asset class. During the five-year period from 1977 through 1981, the federal discount rate rose nearly 800 basis points from 5.46% to 13.42%. During this time, the five-year annualized return of U.S. T-Bills was 9.84%. The one to five year government bond index rose 6.61% during this time frame. Neither of these annual return rates are great, but they are not Armageddon either. The next period of rising interest rates was from 2002 to 2006. During this five-year period, the federal discount rate increased from 1.17% to 5.96%. T-bills returned 2.64% annually during this time period and the one to five year index returned 3.77%. My take is that rather than get out of an asset class all together, it makes sense to reduce the duration of the portfolio. The primary problems with getting out of the bond asset class are (1) where does an investor move their money and (2) when does an investor move back into an asset class. History shows that any form of market timing requires the investor to be right twice and that is very difficult indeed. Also, keep in mind that the reason that interest rates move up and down is based on economic conditions. That is, the reason that the Fed will increase interest rates is in response to anticipated inflation, that is, an improving economy. Thus, an asset allocation strategy that spreads investment dollars between low correlation asset classes has a high probability of real returns over a reasonable time period. Trying to time when to get into and out of an asset class has a low probability of success. Again, thanks for you thoughtful article.
smjuetten Reducing the duration is an obviously valid strategy to reduce risk in the interest rate sector during a rising interest rate environment. However, that was not the point of this post. It wasn’t titled the “Great T-Bill Bubble” or “T-Note Bubble”. It was titled the “The Great Bond Bubble” because that is where the problem is. I agree that if you look at 3-5 year yields on 1-5 year duration paper that you will come out whole ignoring default risk. That is inherently baked into the math equation and says nothing new since you are holding the notes and bills to maturity so your return is essentially the interest return. We can agree on that, but it is not the issue. Again, that says nothing regarding the concepts discussed in this post except that one potentially valid risk management strategy is to choose to shorten duration to the pathetically low interest rates available. If you are attached to having assets in the interest rate sector as part of your asset allocation and you are willing to accept the artificially low returns available in that sector then you’ve clearly got your answer. However, this site is about wealth building and nobody builds wealth on 1-3% returns compounded when a reasonable expectation for inflation exceeds that return. The goal for investing is returns in excess of long term inflation to increase purchasing power. My opinion is short duration notes and bills do not satisfy that objective at this time thus my position to exit the asset class. The interest rate sector simply doesn’t make sense on a risk/reward basis. That is my sole contention and nothing you’ve said changes that. In addition, the returns in this asset class since I wrote this post in late February, 2013 support my contention as well by providing negative returns (except in ultra-short duration notes or bills where returns are positive but so low as to be meaningless). Finally, beware of your correlation assumptions between asset classes based on historical research. The primary reason bonds show up prominently in mean-variance portfolio optimizations over historical data and carry strong weight in historically optimized portfolios has to do with their historical bull market and the excellent risk/reward they have provided combined with the historical correlation. Should the risk/reward change as I’m stating in this article (and as proven by subsequent data), then the MVO and portfolio studies will reflect a completely different optimal portfolio, but by then the horse will already be out of the barn. That is the difference between the type of analysis I’m providing here and the type you are quoting. I hope this long-winded answer was helpful in sorting out these issues.
Sage advice Todd. Your comments about timing the bursting of this bubble ring very true. Personally, I thought bond prices were getting irrationally high by the spring of 2011 and shifted more to equities and short duration treasuries only to watch bonds go even higher over the last few years. Although it can test a person’s patience if you recognize a bubble and adjust in the early stages, I think your philosophy of using expectancy investing principles is a very logical way to ensure our financial freedom nest egg is sustained and thrives over the long term. Thanks for sharing this wise counsel.
Thanks for the comment, Irwin. I’m glad you enjoyed the bit about using expectancy investing principles!
Excellent article Todd. IT is clear the bubble and the bad risk to reward. But were to park the money in a low risk money in the wake of a market correction. Like you did in late 90s and mid 2000? Like it is a sound strategy to park the money when a certain asset class looks overvalued.
Now stocks look “expensive”…
My question is. Where to park the money? CASH?
On a long term perspective I agree with your principle to find good risk to reward and high expected value.
Cheers
There is no date on this post that I can find. When was it published?
You didn’t read it very carefully. It states right in the opening few paragraphs that it was published March 2013 and no text has been changed without special notation to preserve the integrity of the claims and statements made.
Todd,
Thank you for this article, amazing how relevant it is five years on. Would you mind adding further comment on shorting the bond market. With Fed tightening and rates likely to rise over time, it seems like a reasonable option.
Yes, time tells all truths. The market behavior subsequent to the publishing date has certainly vindicated the analysis. Regarding your question, exiting the market is removing one type of risk. Shorting the market is adding a different type of risk. They are fundamentally different. For example, I would have lost money shorting since the publication date, but exiting the market has cost me nothing since publication, and actually worked in my favor, exactly as the analysis claimed would happen. Additionally, markets “behave” differently on the short side. The expectancy mathematics are very different, and much more difficult to manage. The complication involved is beyond the scope of a blog comment.
Hi Todd
Thanks for this great article. I am just starting out on investing and liked the idea of Stock to Bonds at 50/50 (Bogle), however whenever I look at the current Bond market index funds they seem to be going negative and the interest rates seem to be set to rise over 2019, which from my limited understanding will negatively affect Bonds more. So I decided to sit cash in High Yield savings at 2.20%, as my low risk hedge to a S&P500 low cost index fund.
Late 2019 and rates are declining. But, as mentioned in this article, how much lower before we hit negative rates and then we eventually go up again. Hard to time, but love the food for thought. Thanks Todd! Any thoughts on the bond market as Fed lower rates?
Nothing to add 6 years after publishing this article. The analysis and conclusions remain 100% spot on. We have been working through a long-term, sideways consolidation resulting in the worst 5 year returns in bond market history since this article was published. As stated, this was the “best case” scenario… so far. The original analysis has stood the test of time and remains completely valid today… 6 years later.
Todd, while I respect your opinion, the academic research suggests that advisors are just as poor at market timing the bond market as they are at market timing the equities market. The S&P Bond index is up 8.2% this year, and 3.6% avg/yr over the last 3 years, just what it should be doing in a well designed portfolio. These bond are also paying dividends, increasing the total return. While less spectacular than equities, the risk adjusted returns have been fine, and I have done much better than the index by selecting good individual bond values and owning index funds, roughly 20% of my financial assets. I know many advisors sell fear stories to add complexity, when a simple index fund portfolio of stocks and bonds will meet most financial goals, without any advisory fees. I hope this message is understood, as I see a lot of good materials shared. Bonds are a solid asset type and lending money is a core business activity, less risky than equities or renting assets like property, hence less attractive in economic good times, but often in a better position in downtimes. Thanks for being open to comments.
I’m glad your bond investments have apparently worked well for you over the short-term, Steve. However, I will provide a couple of different caveats to your analysis. First off, subsequent to this post publishing date, the bond market has provided the worst 5 year returns in all of recorded history, thus vindicating the analysis. You state several very short-term numbers which does nothing to contradict the analysis. Short term results of one year or three years are random at best. What matters is full-cycle results, unless your are a short-term trader (1-5 years). This analysis accepts that bonds can provide acceptable short-term trading results as prices and interest rates go through normal fluctuations, but over a full market cycle it is mathematically impossible for bonds to provide acceptable returns net of inflation. This is a math fact, and it’s not disputable. Time has already told this truth (as evidenced by subsequent market results stated above) and will continue to prove it out as short-term fluctuations mean revert to full-cycle results. This is not about timing, as you allude to, and it has no relationship to the academic research you discuss. It’s simply math truth. I stated it in this article and I’ll state it again in this comment, bonds have no positive expectancy as a long-term asset allocation position in a portfolio until interest rates significantly increase resulting in losses to those (like yourself) who own bonds at that time. That’s a math fact, not a prediction or market timing. Until that occurs, bonds are merely a short-term trading vehicle. Congratulations on getting the short-term right. Hopefully, you won’t be part of the inevitable losses that occur to those that hold for the long term. I hope that helps.