Bond "Bubble" Fears Overblown?
American Century Investments
November 30, 2010
Bond “Bubble” Fears Overblown? Economic and Behavioral Factors Argue for Persistent Bond Demand Over Time
In this paper, we consider the argument that there is a bond “bubble” in the context of current economic and market conditions. We examine academic literature for commonly accepted characteristics of speculative bubbles, finding little evidence to support the notion that the bond market is currently experiencing a “bubble.” Nor do we believe the term “bubble”—as it is often associated with short, sharp price changes in more volatile stock and commodity markets—accurately reflects the current reality of bond investing. In making this assertion, we reference our own proprietary analysis as well as recent academic studies of investor behavior. 
Interest rates could rise over time, resulting in short-term losses for bond investors. However, the case for a bond “bubble” rests on the assumption that the market faces a sea change in interest rates, with investors abandoning bonds for stocks and other assets. On the contrary, we find that the economic conditions necessary to spark a sustained bond market selloff (inflationary conditions or a pre-emptive Federal Reserve rate hike) are lacking in today’s environment of stagnant growth, modest inflation, and low interest rates. We also believe that demand for bonds should persist given the effects on investor risk appetites following a prolonged period of poor equity returns.
Finally, we look at the portfolio management implications of prevailing economic and market conditions for fixed-income investors. We argue that a sophisticated, multi-faceted approach, using strategies designed to maximize risk-adjusted performance over time, is best suited to the current environment. Indeed, an approach that attempts to minimize risk and maximize yield and return potential should be a central tenet of all bond investing, regardless of one’s position on the bond “bubble” debate.
The case for a bond “bubble”
Record-low interest rates and unprecedented demand for bonds, combined with outperformance relative to stocks for an extended period, have led some pundits to suggest bonds might be experiencing a “bubble,” with prices vulnerable to sharp declines.
Bond “bubble” advocates base their argument on a number of points. They say that fixed-income performance has been buoyed by a series of what they deem unsustainable supports for bond prices—low inflation and a policy of historically low short-term interest rates by the Federal Reserve (Fed). Those in the bond “bubble” camp argue that as inflation pressures increase (as economic conditions improve and/or in response to the unprecedented amounts of fiscal and monetary stimulus provided to ward off a global depression as the Credit Crisis and Great Recession unfolded), the Fed’s short-term rate target and Treasury yields will shift dramatically higher from current levels, putting price pressure on the entire bond market.
Furthermore, bond “bubble” proponents note that net inflows to bond mutual funds reached a record high in 2009, and remained strong through the first half of 2010. Much of this buying is being driven by underperformance in other assets, particularly stocks and real estate. Indeed, bonds outperformed stocks during the “Lost Decade” of the 2000s, which many analysts suggest is a sign of an impending reversal.
Following this logic, bond “bubble” advocates argue that a sustained recovery by stocks would likely result in a sharp bond selloff as investors shift back to riskier equities. This argument fundamentally sees stocks and bonds as competing, rather than complementary, assets.
Why “bond” and “bubble” do not belong in the same sentence
Bubbles are typically associated with the following characteristics: sharp, short-term price increases followed by dramatic losses; the use of leverage to fuel speculation; euphoria about the asset; a focus on price gains rather than income payouts; and a short-term holding period. These are all at odds with the traditional rationale for bond investing, which emphasizes relative price stability, income generation, and typically long-term holding periods.
Extensive academic research on speculative bubbles is available, with contributions from such widely divergent fields as economic history and behavioral finance on the one hand, to mathematics and physics on the other. A survey of this literature yields several common characteristics associated with market bubbles. These include the use of leverage; euphoria (or at least broad optimism) about the asset in question; a focus on short-term price gains rather than a long-term, dividend-based approach; and a technological or other exogenous catalyst for growth, among other factors. Perhaps most important, these bubbles tend to display significant short-term price increases above fundamental value driven by excessive speculation, followed by precipitous price declines, often resulting in losses that can take many years to recoup. The literature naturally tends to focus on bubbles in stocks, tulips and other commodities, as well as real estate.
Here we note one important similarity between Internet stocks and Dutch tulip bulbs in bubble literature—neither one writes you a dividend check. Indeed, in classic asset bubbles, investors do not seek income, but are almost exclusively focused on capitalizing on short-term price gains. These factors are in direct conflict with typical investor rationale for bond investing. In fact, we’d argue that a key reason why investors are buying bonds now is because they don’t want the price volatility of stocks, Also, the strong inherent demand for income from bonds appears to preclude the type of short-term holding behavior that is characteristic of bubbles.
To continue reading this commentary click here.
(c) American Century Investments
