Is the Bond Market in a Bubble?

Bonds have been on a 34-year bullish run, but that may come to an end soon.

With the stock market in its sixth year of a bull market and hitting all-time highs, many investors are looking for vulnerable areas that may be susceptible for a pullback, or what I like to call a “bubble watch.”

Most of these conversations tend to drift toward areas where we’ve recently had bubbles burst, liketechnology stocks during the dot-com era or real estate in the mid-2000s. However, the asset class that seems to be vulnerable is bonds.

This is particularly concerning since many investors use fixed income to reduce volatility and limit downside risk. In fact, many strictly adhere to conventional asset allocation rules that dictate a fixed portion of their retirement assets are put in bonds, depending on age, without much consideration for future returns or risks.

Most investors may be aware that interest rates are near record lows and that bond prices are inversely related to rates. They are also probably aware that the Federal Reserve ended its quantitative easing program and is now looking to begin raising short-term interest rates. However, I question whether many understand the extent of such risks.

Similar to the environments leading up to the corrections in technology stocks and real estate years ago, most acknowledge that there is at least some froth, but don’t see an imminent danger, or they underestimate the magnitude of a possible correction. Yet, complacency can be dangerous. In the following, I will try to give some perspective of the risks in the bond market.

Yes, bonds can fall. Since the 10-year Treasury rate peaked at nearly 16 percent in 1981, bonds have been in an amazing 34-year bull market. In fact, the run has been so long, many investors have never seen a bear market in fixed income. However, they most certainly exist.

According to data from Ibbotson Associates, long-term government bonds fell more than 8 percent from 1955 to 1959 as yields on the 10-year Treasury rose from 2.61 percent to 4.72 percent. The worst year for long-term government bonds was in 1969, when rising interest rates and rampant inflation caused price declines of 20 percent to 30 percent.

Another ugly period occurred in late 1994, when a bond disaster destroyed $1 trillion in assets, which was caused by the Fed raising short-term rates, and was amplified by the use of derivatives and leverage.

Today, the 30-year U.S. Treasury bond yields just under 3 percent, which is less than half of its 6.8 percent average over the past five decades. Just a 1 percent yield increase on that instrument would produce an estimated decline of nearly 20 percent.

While the drops are typically not as dramatic as the stock market, bond price declines can be meaningful and last for multiple years. This could prove to be very problematic for those depending on bonds for downside protection and low volatility.

There are signs of rising bond risk. For years, many have been calling for an increase in interest rates and the end of the bond bull market. While such doomsayers have been proven wrong thus far, there have been warning signs of heightened risk.

For example, there was a recent “flash crash” in U.S. Treasuries in October 2014. The yield on the 10-year fell 0.34 percent in a matter of minutes. While that doesn’t appear to be much on the surface, such volatility has been surpassed only once in the past 50 years.

Now a large bond brokerage firm is considering installing circuit breakers to temporarily halt trading in Treasuries following large price moves. While circuit breakers have been used in the stock market for some time, this would be a first for U.S. government bonds. This is particularly concerning since traditionally these have been considered one of the most liquid investment classes.

Another recent example is how the brokerage firm UBS reclassified its clients that were heavily invested in bonds from being “conservative” to “aggressive,” likely to lessen any possible future legal liability. While these examples may not prove to be “canaries in the coal mine,” I strongly believe that the risk level of bonds has risen significantly.

There is a large contingent of investors that have never seen a bond bear market. Couple this with rising volatility and lower liquidity, and what you could end up with is trillions of dollars rushing for the exit at the same time with few buyers. If you must, own individual bonds because you can at least get your principal back if you hold it to maturity.

High-yield investments are also vulnerable to increases. While stocks have been on a tear over recent years, it’s been a tough market for investors that require income-producing assets. Instead of locking up money for 30 years in a U.S. government bond to only receive a 3 percent annual yield, many have turned to high-yielding alternatives, including high-dividend stocks, master limited partnerships or real estate investment trusts. In fact, investors have plowed nearly $50 billion into mutual funds and exchange-traded funds that track utilities and REITs from 2010 to 2014, according to Morningstar.

However, there is no such thing as a free lunch. As we saw during the May 2013 “taper tantrum,” these investments are also susceptible to rising interest rates. The reason is because government bonds carry higher credit quality than REITs, MLPs or high-yielding stocks. If the yield on those bonds rise to become equivalent, investors will sell the income alternatives to purchase the higher credit quality. Don’t expose yourself to considerable downside risk by reaching for high yields.

Investors that require income are faced with a difficult and uncertain environment. I believe fixed income currently is a high-risk, low-return asset class. If bonds are a cornerstone of your portfolio, understand the associated risks so that you can properly position yourself for a rising rate environment. Shorten duration, improve credit quality and don’t reach for yield.

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