'Bubble' Bashing Does Not Imply Risk-Free Bond Outlook
November 2, 2010
Sometimes, market commentators have to step back and clarify their positions, lest they be misconstrued. This is one of those times.
Almost two months ago (for the week of September 6), we published a Weekly Market Update titled “Latest Bond ‘Bubble’ Fears Are Overblown.” That piece reviewed and dissected recent “bubble” arguments, subjecting them to the scrutiny, analysis, and research of the fixed-income team at American Century Investments. The team’s opinion, as summarized in the Update’s conclusion, read:
“Despite considerable discussion in the financial media about the existence of a bond market bubble, the fixed-income team at American Century Investments® finds little evidence to support this claim. None of the factors traditionally associated with asset bubbles are at work in the bond market at present. Bond bubble proponents base their argument largely on record flows into fixed-income investments, bonds' extended outperformance over stocks, and record low interest rates. However, a confluence of economic headwinds argues for a prolonged period of low interest rates and inflation, while investor demographic and behavioral finance trends also appear to favor further bond inflows.”
Clarifying Our Strong Stance
The fixed-income team and its leader, Chief Investment Officer David MacEwen, stand solidly behind that position, which has been reiterated numerous times over the last two months. However, our strong “this doesn’t fit previous ‘bubble’ profiles” stance prompted an interesting question: Does it imply a correspondingly strong long-term bullish outlook for the U.S. bond market, and suggest that bond positions can be built at this point without risk of loss? This issue came up specifically with regard to the team’s recent suggestions (to risk-conscious investors seeking income and/or diversification) to consider building or maintaining short- or intermediate-maturity professionally managed diversified bond positions.
The answer to the two-part question is an emphatic “no and no.” Suggesting to investors that they consider diversifying with bonds and focusing on short- and intermediate-maturity bond positions is not inherently “long-term bond bullish” or “risk-free investment” talk. It’s simply reiterating a sound, established risk-management strategy to help reduce portfolio volatility. Furthermore, our fixed-income team’s extensive counterarguments against an alleged bond “bubble” do not imply any particular longer-term outlook for interest rates and the bond market, or suggest that the market is presently risk free.
It’s important to note (as we did in our Sept. 27 Weekly Market Update, “Challenges and Solutions for Income-Seeking Investors”) that historically low interest rates could continue for some months to come, according to the U.S. Federal Reserve. The Fed said in its last policy statement, on Sept. 21, that “inflation is likely to remain subdued for some time” and “The Committee…continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.”
But beyond the next three to six months, it’s anyone’s guess what could happen. History suggests that we may be closer to the end of the “prolonged period of low interest rates” than the beginning, and it also suggests that interest rates and Treasury yields are more likely to rise from these historically low levels over time than fall, which would cause bond prices to decline. Present weak economic conditions indicate that this risk may not be immediate, but it definitely does exist.
Holding Period and Diversification Help Address Rising Rate Concerns
Those interest rate risks can be managed and reduced. Extensive scenario and portfolio analysis by our fixed-income team shows that a long-term holding period and a diversified investment approach for bond investing can help offset the damaging effects of rising interest rates, if or when they occur. Even under extreme hypothetical interest-rate increase scenarios, short- and intermediate-maturity bond fund returns can shift positive three to four years after a price shock for those who hold rather than sell. Compare this with stock investors who are still waiting for positive cumulative returns a decade after the tech bubble burst. And the longer you hold bond funds, especially those with higher-yielding bonds, the more their income component can help offset price declines.
Diversification is another important component in an effective risk-management toolbox. Just as adding bonds to a stock portfolio can help lessen losses during an economic downturn, ensuring you have a mix of bonds, particularly higher-yielding non-Treasury assets, in a professionally managed portfolio can help reduce bond losses during an economic upturn.
Conclusion
The fixed-income team at American Century Investments still doesn’t believe that the present bond environment fits previous “bubble” profiles. But, at the same time, it wants to clearly acknowledge that we’re in a period of historically low interest rates and Treasury yields, with more room to rise than fall. Future bond price declines are a realistic expectation, but the team doesn’t think they’re likely to rival other post-bubble, extended price plunges. Bonds continue to provide a cushion for equity exposure in diversified portfolios and a source of steady income for those who need it. And we believe interest rate risk exposure can be effectively managed in bond portfolios with shorter maturities, longer holding periods, and increased diversification. Take a look at our short- and intermediate-term diversified core bond fund offerings, as well as our other more specialized bond funds that can help diversify and add different return characteristics to an existing portfolio.
American Century Investments® offers a wide variety of stock, bond, asset allocation and money market funds. Visit americancentury.com for more information: U.S Investment Professionals
Diversification does not ensure a profit and cannot protect against a loss in a down market. Investment return and principal value will fluctuate, and it is possible to lose money by investing.
Generally, as interest rates rise, bond prices fall. The opposite is true when interest rates decline.
The opinions expressed are those of American Century Investments and are no guarantee of the future performance of any American Century Investments portfolio. This information is not intended to serve as investment advice; it is for educational purposes only.
You should consider a fund’s investment objectives, risks, and charges and expenses carefully before you invest. The fund’s prospectus or summary prospectus, contains this and other information about the fund, and should be read carefully before investing. Investments are subject to market risk.
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