What Bond Market Bubble?

Steve McDonald By Steve McDonald
Bond Strategist, The Oxford Club

Bond Investing

The predictions of a bond market bubble and/or the collapse of the bond market have been nonstop since interest rates started to drop after the stock market collapse in 2008.

In fact, with rare exception, there has been almost no other bond news. The headlines either tout the death of bonds or simply say that bonds are overpriced.

That’s six continuous years of consistently bad calls that have kept people out of bonds and have cost income investors a lot of money.

During the same six years, I have been able to post returns on closed bond trades of between 15% and 40% a year at The Oxford Club. My open positions for my research service Oxford Bond Advantage, even in what most consider an overpriced bond market, are returning 5% to 20% a year.

Just the yields to maturity (YTM) on my corporate bonds are beating the return of the stock market this year.

That’s a huge discrepancy between what the money press is saying about bonds and what is really happening.

Something is very wrong.

Value and Reality

Let’s ignore the fact that no one has held anyone’s feet to the fire for being wrong for so long about bonds. And believe me, no one has even been close to calling this market correctly, except for maybe yours truly.

So, the question now is… are they finally right? Is there finally a bubble in bonds?

The answer is the same one I’ve given my readers every year since 2008… No. On so many levels, no.

A bubble is defined as irrational buying by folks who believe they have missed the market and buy anything at any price. Value and reality are out the window. Think housing 2005 through 2007.

Based on what I have seen for the past few years, virtually no one except institutions and my readers have been buying bonds. In fact, there is not now, nor has there been, any irrational buying in bonds.

The exact opposite has been true.

Scared to Act

Investors, driven by the hugely negative press, have been overcautious about bonds and have stayed out of them.

This is not the market sentiment you have in a bubble.

A bubble also should have highly inflated prices and prices driven by nothing but the momentum of the buying.

Bond prices are actually well below the highs of 2012. Remember, rates hit an intraday low of 1.38% on the 10-year Treasury in July of 2012. We are now around 2.4% and were up at 3.3%.

From 2012, we have moved to lower prices, not higher. Prices go up in bubbles, not down.

Plus, bond buying – especially in corporates – has been driven by the healthiest balance sheets ever, not the momentum of the buying!

Bubbles also occur under the assumption that there is an issue with inflation in the broad economy. The concern most economists have now is deflation, not inflation.

If this is not making any sense, you’re right. It does not and has not for some time. Nothing in the current bond market is pointing to a bubble.

And it gets worse. The negative inaccurate reporting about bonds isn’t just about a bubble.

Unwarranted Press

Corporate bonds, especially junk bonds rated below BBB, always take the worst beating in the press. Since the 1980s, when Michael Milken created the whole concept of junk bonds, they have been the bad boys of the investment world. This market is no different.

Ask any stock broker, and he’ll tell you to stay away from junk bonds because they are too risky.

Risky? In the current market, they have a 98% success rate. That means they pay their interest and return their principal at maturity exactly as promised 98% of the time. Long term, since 1925, they have done the same about 94% of the time.

I must have a different idea of what constitutes risky. A success rate between 94% and 98% seems pretty good to me.

Meanwhile, the news about corporates has been overwhelmingly negative. That does not jibe with the returns I have seen.

Ignore the Sell-Off

In late July, there was the single biggest one-week sale of bond funds and ETFs in the market’s history. The sell-off totaled $7 billion in one week!

However, it was all done by small investors. That’s who owns bond funds and ETFs.

No one has been able to figure out exactly what triggered it – analysts assume it was the Middle East and Russia and the Ukraine – but it didn’t matter. As soon as the selling eased, institutions stepped in and bought up everything that wasn’t nailed down.

The result was almost no change in prices. Any weakness the small investors’ selling created was negated by the institutional buying.

In a bubble, the small investor jumps in with both feet; institutions do not.

On so many levels, this bond market is not in a bubble. But that is not to say that some parts of it are not overpriced or that you can just dive in and buy anything.

The Place to Be

Treasury prices are high and the yields are so low that it makes no sense to own them. The 10-year yields about 2.4%, which in dollar terms means you will earn $240 in interest if you hold a $1,000 bond for 10 years.

It’s absurd, I know. But these bonds aren’t showing signs of changing anytime soon.

Municipal bonds are priced a little better now than they have been, but they are still paying too little for me to buy.

That leaves corporate bonds, and that’s where I have always thought most small investors should have their bond money.

The market is tighter and yields aren’t as good as they were a few years ago but, as I said earlier, I am earning between 5% and 20% a year right now on my bonds just on my YTMs.

In corporate bonds, we can also do much better than the YTM if a company’s underlying fundamentals continue to improve and we sell for a capital gain before maturity.

The bottom line is this. The bond market has moved up in price. In some parts, it is overpriced, but that does not constitute a bubble or indicate a collapse. What it does mean is we will see selling when rates finally move up, and that will generate lower prices for some bonds, not a collapse or the death of bonds.

The money press is dominated by stock analysts who think they understand the bond market. Six years of bad guesses should tell you how much they do not.