Market participants’ constant preoccupation with spotting the next bubble in financial markets has spread to the bond market. Citing low yields, high bond prices, and strong mutual fund flows (according to Investment Company Institute (ICI) data), talk of a bond bubble has recently become more frequent in the financial media. The term bubble, which was used to describe tech and telecom stocks in the late 1990s, and of course, more famously used for the housing market in recent years, is associated with sky-high prices that selloff abruptly and violently and hand investors significant losses in the process. We strongly disagree with the notion that the bond market as a whole is a bubble waiting to burst. While Treasury prices are expensive, we believe current pricing is a reflection of underlying fundamentals rather than a speculative boom.
Proponents of the bond bubble argument will often cite low yields and then apply a price-to-earnings (PE) ratio to bonds. For example, dividing the par price of the 10-year Treasury note (100) by the 2.6% yield of the note (as of August 23, 2010) results in a “bond PE” of 38 (100 divided by 2.6), similar to what the stock market witnessed in the late 1990s. Applying a stock metric such as PE to bonds is flawed in our view. Assuming no default, bonds repay principal at maturity unlike stocks where there is no set redemption value. Using such a rationale for short-term securities, in particular, does not take
into account the fact investors will get their money back sooner and the lower yields reflect the reduced interest rate risk relative to longer-term bonds.
High Quality Bonds
We agree that high-quality bonds are expensive relative to stocks but relative value is different than bubble talk. The bond PE measure is often then compared to stocks to show how expensive bonds are relative to stocks. With second quarter earnings season all but finished, 12-month trailing S&P 500 earnings are on track to reach roughly $75 per share according to Bloomberg data. Dividing the $75 earnings-per-share level with price level of the S&P 500 Index of 1067 (as of August 23, 2010) produces an earnings yield of 7.02% (75 divided by 1067). This yield is significantly higher than that of the 10-year Treasury and implies greater value. We believe this speaks to the greater return potential of stocks relative to bonds over the long-term and the prospect of low high-quality bond returns over that time but not a bubble.
Treasury yields reflect fundamental economic and financial market conditions. As we discussed in last week’s Bond Market Perspectives, inflation and the Federal Reserve (Fed) are the two main drivers of interest rates. Core inflation, as measured by the Consumer Price Index (CPI) less volatile food and energy prices, is running at less than a 1% annualized rate,a multi-decade low, and is expected to remain low over the remainder of the 2010. Inflation-adjusted yields (also known as real yields) indicate the Treasury market is expensive on a valuation basis but not at an extreme. The higher the real yield the more attractive bonds are and vice versa. Real yields indicate Treasury valuations are on the expensive side of the past 10 years but not at the extreme witnessed during the fall of 2008 or even during the first quarter of 2008 when Bear Stearns failed.
Short Term Yields
Short-term Treasury yields are highly correlated to the level of the Federal Funds target rate set by the Federal Reserve. Record-low short-term Treasury yields are largely a reflection of the similarly record-low overnight lending rates. Furthermore, by committing to Treasury purchases, the Fed has reiterated its “lower for longer” message and reinforced the low level of short-term Treasury yields. The worst yearly performance of the bond market, as measured by the Barclays Aggregate Bond Index, was 2.9% and occurred in 1994. What was the catalyst? The Fed hiked interest rates by three percentage points over a 13-month span. The Fed’s impact should not be underestimated.
Bond bubble proponents have cited inflows into bond mutual funds as cause for alarm. To be sure, inflows into bond funds have been robust since the end of 2008, totaling $529 billion according to ICI data from January 2009 through June 2010, and have come at the expense of stocks. Comparing bond fund flows to the bond market total returns, as measured by the Barclays Aggregate Index reveals that inflows do have an impact on bond returns over longer time periods such as 3 months. However, the correlation is modest at best and in our view does not fully explain bond performance. Note during late 1999 through 2000 bond fund inflows were negative yet bonds experienced strong performance. Similarly, there are discrepancies in the middle part of the last decade as well and current fund inflows would have suggested even stronger performance than what investors have experienced in the past two years.
A sharp reversal of bond fund inflows would certainly be a headwind for bond performance but it does not capture all the drivers of bond performance. In addition to the fundamental drivers of inflation and the Fed,fund inflows also do not reflect changing risk tolerances among investors, some of which were permanently changed following the financial crisis.Some investors feature bonds more prominently in their portfolios as a result and the demographics of an aging population also explain a greater reliance on bonds. Lastly, and on a related note, bond fund inflows do not capture institutional investors, including managers of pensions and endowments, which represent a significant presence in the bond market.
What’s Going On Abroad
Foreign buying has also been cited as a crutch the Treasury market cannot do without. Recently released Treasury International Capital (TIC) data revealed that foreigners actually increased their purchases of Treasuries over the first six months of 2010, purchasing a total of $344 billion compared to $331 billion during the second half of 2009 and $208 billion over the first half of 2009. The European debt problem likely contributed to foreign Treasury purchases. The impact of foreign debt purchases is also questionable as foreigners have been net sellers of corporate bonds over the past 18months
yet it is the strongest performing sector in the bond market over that time. Still, we do not dismiss the impact of foreign buying of Treasuries and will monitor closely. Central banks tend to move at glacial speeds and any change to Treasury buying habits are likely to come over many years. This could potentially be a drag on future bond performance, but it will be very gradual and hardly equivalent to bursting of a bubble.
In sum, current bond prices and yields are largely a reflection of current fundamental drivers and not the speculative forces that create asset “bubbles”. High valuations and low yields do imply low rates of returns for bond investors over coming years and may even result in an occasional negative return as low yields provide less of a cushion against rising rates.
However, this is an important distinction to make relative to a bubble talk that is typically associated with an asset price decline of 10-20% or more over short one to two-year time frames, something we think is highly unlikely for high-quality bonds.
IMPORTANT DISCLOSURES
- The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
- The Barclays Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment-grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.
- High-Yield/Junk Bonds are not investment-grade securities, involve substantial risks, and generally should be part of the diversified portfolio of sophisticated investors.
- The market value of Corporate Bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield.
- Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of funds shares is not guaranteed and will fluctuate.
- Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise, are subject to availability, and change in price.
- Past performance is no guarantee of future results.
- Investors should consider the investment objectives, risks, charges and expenses of the investment company carefully before investing. The prospectus contains this and other information about the investment company. They can obtain a prospectus from you. Read carefully before investing.
- Consumer Price index (CPI) is a measure estimating the average price of consumer goods and services purchased by households.
- The P/E ratio (price-to-earnings ratio) is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share. It is a financial ratio used for valuation: a higher P/E ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with lower P/E ratio.
- The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
- Correlation is a statistical measure of how two securities move in relation to each other. Correlations are used in advanced portfolio management.
- The Investment Company Institute (ICI) is the national association of U.S. investment companies, including mutual funds, closed-end funds, exchange-traded funds (ETFs), and unit investment trusts (UITs). Members of ICI manage total assets of $11.18 trillion and serve nearly 90 million shareholders.
- Treasury International Capital (TIC) is select groups of capital which are monitored with regards to their international movement. Treasury international capital is used as an economic indicator that tracks the flow of Treasury and agency securities, as well as corporate bonds and equities, into and out of the United States.
- TIC data is important to investors, especially with the increasing amount of foreign participation in the U.S.financial markets
Say No to the Bond Bubble
by Jeff Rose
Market participants’ constant preoccupation with spotting the next bubble in financial markets has spread to the bond market. Citing low yields, high bond prices, and strong mutual fund flows (according to Investment Company Institute (ICI) data), talk of a bond bubble has recently become more frequent in the financial media. The term bubble, which was used to describe tech and telecom stocks in the late 1990s, and of course, more famously used for the housing market in recent years, is associated with sky-high prices that selloff abruptly and violently and hand investors significant losses in the process. We strongly disagree with the notion that the bond market as a whole is a bubble waiting to burst. While Treasury prices are expensive, we believe current pricing is a reflection of underlying fundamentals rather than a speculative boom.
Proponents of the bond bubble argument will often cite low yields and then apply a price-to-earnings (PE) ratio to bonds. For example, dividing the par price of the 10-year Treasury note (100) by the 2.6% yield of the note (as of August 23, 2010) results in a “bond PE” of 38 (100 divided by 2.6), similar to what the stock market witnessed in the late 1990s. Applying a stock metric such as PE to bonds is flawed in our view. Assuming no default, bonds repay principal at maturity unlike stocks where there is no set redemption value. Using such a rationale for short-term securities, in particular, does not take
into account the fact investors will get their money back sooner and the lower yields reflect the reduced interest rate risk relative to longer-term bonds.
High Quality Bonds
We agree that high-quality bonds are expensive relative to stocks but relative value is different than bubble talk. The bond PE measure is often then compared to stocks to show how expensive bonds are relative to stocks. With second quarter earnings season all but finished, 12-month trailing S&P 500 earnings are on track to reach roughly $75 per share according to Bloomberg data. Dividing the $75 earnings-per-share level with price level of the S&P 500 Index of 1067 (as of August 23, 2010) produces an earnings yield of 7.02% (75 divided by 1067). This yield is significantly higher than that of the 10-year Treasury and implies greater value. We believe this speaks to the greater return potential of stocks relative to bonds over the long-term and the prospect of low high-quality bond returns over that time but not a bubble.
Treasury yields reflect fundamental economic and financial market conditions. As we discussed in last week’s Bond Market Perspectives, inflation and the Federal Reserve (Fed) are the two main drivers of interest rates. Core inflation, as measured by the Consumer Price Index (CPI) less volatile food and energy prices, is running at less than a 1% annualized rate,a multi-decade low, and is expected to remain low over the remainder of the 2010. Inflation-adjusted yields (also known as real yields) indicate the Treasury market is expensive on a valuation basis but not at an extreme. The higher the real yield the more attractive bonds are and vice versa. Real yields indicate Treasury valuations are on the expensive side of the past 10 years but not at the extreme witnessed during the fall of 2008 or even during the first quarter of 2008 when Bear Stearns failed.
Short Term Yields
Short-term Treasury yields are highly correlated to the level of the Federal Funds target rate set by the Federal Reserve. Record-low short-term Treasury yields are largely a reflection of the similarly record-low overnight lending rates. Furthermore, by committing to Treasury purchases, the Fed has reiterated its “lower for longer” message and reinforced the low level of short-term Treasury yields. The worst yearly performance of the bond market, as measured by the Barclays Aggregate Bond Index, was 2.9% and occurred in 1994. What was the catalyst? The Fed hiked interest rates by three percentage points over a 13-month span. The Fed’s impact should not be underestimated.
Bond bubble proponents have cited inflows into bond mutual funds as cause for alarm. To be sure, inflows into bond funds have been robust since the end of 2008, totaling $529 billion according to ICI data from January 2009 through June 2010, and have come at the expense of stocks. Comparing bond fund flows to the bond market total returns, as measured by the Barclays Aggregate Index reveals that inflows do have an impact on bond returns over longer time periods such as 3 months. However, the correlation is modest at best and in our view does not fully explain bond performance. Note during late 1999 through 2000 bond fund inflows were negative yet bonds experienced strong performance. Similarly, there are discrepancies in the middle part of the last decade as well and current fund inflows would have suggested even stronger performance than what investors have experienced in the past two years.
A sharp reversal of bond fund inflows would certainly be a headwind for bond performance but it does not capture all the drivers of bond performance. In addition to the fundamental drivers of inflation and the Fed,fund inflows also do not reflect changing risk tolerances among investors, some of which were permanently changed following the financial crisis.Some investors feature bonds more prominently in their portfolios as a result and the demographics of an aging population also explain a greater reliance on bonds. Lastly, and on a related note, bond fund inflows do not capture institutional investors, including managers of pensions and endowments, which represent a significant presence in the bond market.
What’s Going On Abroad
Foreign buying has also been cited as a crutch the Treasury market cannot do without. Recently released Treasury International Capital (TIC) data revealed that foreigners actually increased their purchases of Treasuries over the first six months of 2010, purchasing a total of $344 billion compared to $331 billion during the second half of 2009 and $208 billion over the first half of 2009. The European debt problem likely contributed to foreign Treasury purchases. The impact of foreign debt purchases is also questionable as foreigners have been net sellers of corporate bonds over the past 18months
yet it is the strongest performing sector in the bond market over that time. Still, we do not dismiss the impact of foreign buying of Treasuries and will monitor closely. Central banks tend to move at glacial speeds and any change to Treasury buying habits are likely to come over many years. This could potentially be a drag on future bond performance, but it will be very gradual and hardly equivalent to bursting of a bubble.
In sum, current bond prices and yields are largely a reflection of current fundamental drivers and not the speculative forces that create asset “bubbles”. High valuations and low yields do imply low rates of returns for bond investors over coming years and may even result in an occasional negative return as low yields provide less of a cushion against rising rates.
However, this is an important distinction to make relative to a bubble talk that is typically associated with an asset price decline of 10-20% or more over short one to two-year time frames, something we think is highly unlikely for high-quality bonds.
IMPORTANT DISCLOSURES
photo credit: The Infatuated