So, what is the bond bubble, and is it really about to burst? Do you need to prepare for a possible change of course?
Falling rates and false promises set the stage
After a three-decade-long interest rate plunge, the Federal Reserve (the “Fed”) hinted at the return to normalized interest rates several times over the last eight years. Instead, however, the Fed artificially held rates at record lows to help spur economic growth. The Fed believed this policy would open the floodgates to commercial and mortgage lending and significantly accelerate what, to date, has been a tepid economic recovery.
Instead, this decision has turned interest rates into a powder keg that may blow up the bond market at any moment. The Fed’s monetary policy may have driven you and many other fixed-income investors into yield-oriented assets to help generate returns as rates fell. But what happens now as rates begin to steadily rise?
For an indication, you could turn to the words of Sir John Templeton, who said, “Bull markets are born on pessimism, grown on skepticism, mature on optimism, and die on euphoria.”1
The euphoric flood into interest-rate sensitive bonds during the sustained period of falling interest rates may be met with equally-furious herding in the opposite direction as rates start to normalize.
Will the exit be orderly?
Is this potential bond disruption a natural part of a cyclical economy? Perhaps not. Some are concerned about the bond market’s liquidity if there’s a mad dash for the exits. You may not be able to sell certain bonds unless you take a substantial hit in price.2
Imagine a worst-case scenario where the corporate bond market’s liquidity dries up to levels not seen since the Great Recession. Traditionally, banks would swoop in and take those bonds off your hands at a small discount, then turn around and sell them at a profit. That practice was curtailed during the recent regulatory push to make banks more stable. So, if you’re looking to sell, the market of buyers may be limited.
Putting a pin in it
Bonds are coming off a 36-year bull market, inflation is rising with a growing economy, and there are real liquidity concerns in the market. But where’s the pin needed to burst this bubble? Re-enter: the Fed.
A rapid interest rate increase may potentially shock the bond market into a tailspin, but by all indications, Fed Chair Janet Yellen is resisting such an aggressive spike. The Fed is instead looking at the path to normalization more pragmatically with small, steady increases over time. In fact, as the economic outlook and inflation remain muted, those incremental increases are even in doubt. Interest rates could well stay below historical averages for much longer than initially thought.
Planning for the “what if…”
If you’re a fixed-income investor allocated heavily to interest-rate-sensitive bonds, it may be time to re-think your strategy. No matter if the bond bubble bursts today or three years from now, rising interest rates can be kryptonite for fixed-coupon investments. As rates go up, the value of your current bonds go down because you can buy similar bonds on the open market with a higher coupon. So, what can you do?
Option 1: You could allocate more heavily to equities, but that bull market is also long in the tooth, and you may not have the risk capacity to buy into an expensive market.
Option 2: You could look to corporate loans, which seek to mitigate interest rate risk and pay floating-rate coupons that generally increase as interest rates rise.
The “bursting bond bubble” has been a drumbeat for some time, but don’t confuse the market’s durability with the improbability of an eventual explosion. A pin is coming into focus, with an aging bond run hitting the headwinds of rising interest rates and an economy in transition. Be mindful of the markets and plan now for what may come next.