Beware the Bond Bubble

I am not one to throw the term “bubble” around lightly. But recently, at Schwab’s Impact conference for financial advisers, I was on a panel with Schwab Chief Investor Strategist Liz Ann Sonders, and I had to “call it like I see it.”

Moderator Maria Bartiromo of CNBC asked the panel what investments we would avoid. My immediate reply was “bond bubble, bond bubble, bond bubble!” Liz Ann Sonders stopped short of using that same terminology, but called bonds a “fear trade.” She went further saying she saw a “tremendous amount of risk in fixed income.”  Sonders and I are on the same page. We believe that, as a result of the sharp losses in equities from late 2007 to early 2009, people have rushed headlong into bonds, which they associate with low risk. To my mind, an asset class with historically low volatility is not necessarily low risk if its valuation rises well outside its normal range.

Three key factors have to be present before I consider an investment to be a bubble. First, there’s a huge surge of funds into the area; it can’t be a bubble without money inflating it. Second, there are signs of all-time high prices. Finally, the risk/reward fundamentals don’t make sense.

So here’s my case for bonds being in bubble territory.  First, a tidal wave of dollars has come in. According to data from the Investment Company Institute, $404 billion flowed into bond funds in 2008 and 2009, more than the $401 billion that flowed in during the preceding eight years combined (2000-2007).

Second, when judged against history, bond prices are in nosebleed territory.  On Oct. 26, 2010, the U.S. government auctioned off two-year Treasuries at a +0.40% yield, the lowest yield ever.  As many readers know, a bond’s price rises when its yield falls, meaning those two-year Treasuries are at an all-time high price. According to Leuthold, a top-notch investment research firm, many other types of bonds (from short-term commercial paper to long-term Treasuries), were recently near their all-time highs.

Finally, the future performance of bonds is looking less bright. As I write, the 10-Year Treasury bond has a +2.5% interest rate, which means in exchange for $10,000 a bond owner receives $250 each year until receiving the original investment amount back a decade later. That’s a very low return. Furthermore, there’s precious little protection against inflation, a bond’s greatest enemy. Think of it this way: If inflation hits the U.S. Federal Reserve’s preferred average of 1.5%, it will gobble up at least three of every five dollars a 10-year bond owner receives.

What’s the takeaway for our community? African Americans don’t like to lose money, so we tend to be conservative investors. This is why I believe we have participated in the rush to bonds. But bonds are not cash and can lose money. In my opinion, they are poised to do just that over the next few years. If the bond weighting in your personal portfolio has grown, either due to falling stock market values or due to active shifts, I strongly encourage you to rebalance. At these prices, bonds carry more risk than you think.