Where Will You Be When The Bond Bubble Bursts?

I REALLY wanted to title this article “Bonds Have More Fund,” but Google Search Results matter more than my play on words.

Whether you choose to read this article in it’s entirety or just skim through briefly, there is one thing I want you to take away. I want you to know that:

There is a Bubble in the Bond Market and it will pop.

“Is there a bubble?” – or – “Will it pop?” isn’t the question. The question is “Where will you be when it does?”

If you pay the least bit of attention to financial news, this “one take away” comes as no surprise. But it’s still worth mentioning because investors continue to pour record amounts of money into bond funds.

It’s fine if you’re one of them, but you must understand the risks before doing so.

But…I Love Bubbles!

When most of us think about a bubble, real estate comes to mind, only because it’s the most recent. But if you think back further, you may remember these bubbles as well:

• Tulip Mania (1637)
• Stock Market Bubble (1920’s)
• Dot-Com Bubble (2000)

I don’t want to get into the specifics of these prior bubbles, but it helps to be aware of them all. The more you know about past bubbles, the easier it should be to recognize future ones.

The Bond Bubble

The bubble that will soon burst in the bond market is a little different. I say this because the Tulip, Stock, Dot-Com, and Real Estate bubbles all “blew up” fairly quickly. The asset prices inflated rapidly only to come tumbling down shortly after.

The bubble in the bond market has been developing for quite a while. So long, in fact, that bonds have outperformed stocks over the last 30 years. That’s a remarkable claim for an investment regarded as a “slow-growing, less-risky” alternative.

Why Has This Happened?

• Lack of Confidence/Trust in the Stock Market
• Aging Americans Flocking to Safety
• Falling Interest Rates

Let’s focus on the last bullet point.

Over the last 30 years (since about 1980), interest rates have declined steadily. The inverse relationship between interest rates and bond prices means that – as interest rates fall, bond prices rise. This also means that – as interest rates rise, bond prices fall.

That’s about all you need to know.

I have no idea WHEN the FED will choose will be forced to raise interest rates, but I have an idea of WHERE I don’t want to be. I don’t want to be holding long-term bonds – and if I am, I want a maturity date.

I highlight “long-term” and “maturity date” because NOT ALL BONDS ARE CREATED EQUAL.

Duration, Duration, Duration

The duration of a bond can refer to – the length of the bond – or the sensitivity to interest rates. Duration is expressed in years.

A bond with a duration of 4 will be less affected by a rise in interest rates versus a bond with a duration of 10. For this reason, if you’re going to invest in bonds, I recommend looking at a short duration.

Bond Funds vs Individual Bonds

The majority of investors have bond funds, rather than carefully selecting individual bonds. Investing in bond funds is fine, but they should come with a warning.

If you invest in an individual bond, you can hold it until maturity. If you hold it until maturity, the price fluctuations don’t really matter because you’ll receive whatever the coupon rate is.

If you invest in bond funds, there is no maturity date. This is why bond funds will get hit harder than individual bonds whenever the bond bubble pops.

When Will This Bubble Pop?

That’s the tricky question. The FED has entered into QE and Operation Twist, QE2, QE3, and QE Infinity. What this means is that The Federal Reserve is BUYING US Treasury Bonds. This drives down interest rates (it will also lead to loads of inflation, but I’ll save that for another article). In it’s latest round of Quantitative Easing, Ben Bernanke announced that The Fed will continue to buy these bonds until unemployment falls to 6.5% and/or inflation stays below 2.5%. So when will it happen? I don’t know.

If I were a betting man, I would guess between 2014-2018.

The only reason I extend the prediction so far out is because the US won’t be able to pay our bills if interest rates rise. Therefore, The Fed will do whatever it can (printing endless amounts of money) to keep rates low for as long as possible.

Do you own any bonds?