The Next Bubble – Bonds


In their recent Wall Street Journal Editorial, Jeremy Siegel and Jeremy Schwartz discuss the new bubble that is looming, corporate bonds:

http://online.wsj.com/article/SB10001424052748704407804575425384002846058.html

Add this to the list of recent bubbles, which includes the small stock/dot-com stock bubble and the more recent housing bubble.  The good news is that this newest bubble may actually be good news for stocks.

The current bond bubble is driven by two factors.  These are the extremely low interest rates set by the Federal reserve and the flight to safety by the general public.

The Federal Reserve drives down interest rates by lowering the rate it charges for banks to borrow money and by buying Treasuries on the open market to add cash to the system.  These actions affect the Fed Funds Rate the Discount Rate, the main tools of the Federal Reserve.  When this happens, bonds tend to go up in price since the higher returns of bonds are seen as more desirable, which lowers their interest rates.  Stocks also tend to go up since the rate of return offered by stocks is more valuable when the interest rate on bonds decreases (investors are willing to take more risk for a better return).  Because the Federal interest rates are near zero, the price of Treasuries has been bid up to the point where there is almost no yield at all (a scant 1%).

The second factor is that because people are so worried about losing money, they figure that 1% is better than a negative return.  Having been burned by stocks and real estate, along with foreign bonds and stocks, investors are looking for a safe haven.  Because one loses money when bond prices decline, however, the small 1% yield could easily be wiped out if interest rates rise.

So what does this mean?  Stay away from the crowd and out of bonds.  Remember that one never wants to follow the crowd, because wherever the crowd is, prices will be high and all of the money available is already invested.  When there is a bubble this rule is especially true. 

Use this current fear of stocks to buy up shares of good companies.  When the bond bubble bursts, as it will if inflation starts to pick up causing interest rates to rise, the money will come flooding back into stocks.  That is just where you want to be when it does. 

Remember that the high rates of returns from stocks are due mainly to a few brief periods where the market climbs rapidly.  If you are on the sidelines when one of these moves occurs, your rate of return will be far less and your retirement much more meager.

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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

2 comments

  1. almost all investment managers are judged on relative performance. So while there may be no wisdom in the madness of crowds, there’s definitely safety for some.
    These professionals have jobs to save – their own. So they’ll herd more clients towards bonds crashing the market in the bargain. Gold bugs will rejoice.
    The small investors (!) who’ve been told that fixed income is safer will get suckered.
    Maybe if the yield rises a little bit more, you guys should short them bonds.

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