What is a Bond Bubble?

You may have heard of the Dot.com bubble that burst in 2000 or the Real Estate bubble that burst in 2008.  The media seems to like using “Bubble” in the financial industry as much as attaching “gate” to any potential political scandal ever since Watergate 40+ years ago.

As I wrote to clients in my weekly Economic Update a few weeks ago, the rise in short term rates has been fast and dramatic.  The 3-month Treasury bill rate has more than tripled in less than one year!*  The 10-year Treasury has more than doubled since July 2016*. This information isn’t nearly as sexy for the financial media to cover and was “under the radar” for most retail investors.

With Bonds, there is an inverse relationship between prices and interest rates.  Publicly traded Bonds and Bond funds have a price at which they may be sold, and an interest rate that is paid.  When the interest rate environment increases, the price at which a bond or bond may be sold decreases.  The opposite is also true, which is why there has been a 30+ year bull market for Bonds as interest rates steadily declined from the 1980s.

Here is a specific example.  Take the widely held Vanguard Bond Exchange-Traded Fund ticker symbol: BND.  This fund is 100% bonds and, as of this writing, has a yield of 2.53%.  This means if the BND share price does not move, the fund would make 2.53% in a year.  However, this fund is down 2.24% since January 1st (A little over one month)!*

How can this be you ask?  How could a Bond fund be on pace to lose over 15% annualized?  This inverse relationship between interest rates and Bond prices is the answer.  If interest rates stay level, then a Bond price is unaffected.  If interest rates go down, then the Bond owner receives the interest (2.53% for example) and the price of the bond increases if the client wants to sell.  This increases the total investment return for the client above the 2.53% interest rate!  When interest rates increase, the share price goes down and the investor loses value!

Simple question for you; Which direction do you believe interest rates are headed?

We are seeing increasing interest rates contributing to sinking Bond prices.  It is because of this Interest Rate Risk, that we have integrated Fixed and Fixed-Indexed annuities in client portfolios.  Most people seek diversification as a strategy to limit stock market loss.  They don’t want to own 100% stocks.  Using Fixed annuities with guaranteed principle and no fees or expenses, as a replacement for some or all of our client’s Bond positions, has worked very well in this environment.

I have not seen a more wider spread between new Fixed annuity rates and current Bond and Bond fund yields.  The Fixed annuity relative performance on a risk-adjusted, net of fee basis when compared to Bonds and Bond funds is significant.  When Fixed annuity yields are higher than Bond funds, and there are no fees (Gross interest = Net interest) and there is guaranteed principle, this becomes a buying opportunity for clients seeking fixed income yield without interest rate risk.  Additionally, insurance companies have reduced commissions they pay insurance brokers, which is also improving performance for clients.

Diversifying as a strategy to avoid stock market losses is likely more familiar to you.  Diversifying against Bond market losses and interest rate risk may not be as familiar to you.  If you are a PCA client, then we have discussed these strategies.  If you are a not yet a client, don’t take a Bond Bubble Bath!  Let’s get acquainted on the phone, online or in one of our offices.

 

*Bloomberg.com

Disclosures:
A fixed annuity is intended for retirement or other long-term needs. It is intended for a person who has sufficient cash or other liquid assets for living expenses and other unexpected emergencies, such as medical expenses. A fixed annuity is not a registered security or stock market investment and does not directly participate in any stock or equity investments or index.
Guarantees are subject to the claims paying ability of the issuing insurance company.