As retail investor surveys show money continuing to rotate from stocks to bonds - despite sky-high bond prices and their associated ultra-low interest rates - there is increasing concern that investors may soon be blind-sided by at best a savage bond bear market, and at worst a bond bubble that pops. But are investors really buying into bonds because they're bullish on bonds, or because they're bearish on stocks with few appealing alternatives?
After all, if there really is a bond market bubble that's going to pop, the precipitous rise in interest rates could do even more harm to stock prices than bond prices, both from the relative value perspective (who wants to buy the S&P 500 at today's 2% dividend yields when bonds pay 6% again?) and from the economic perspective (a sharp rise in interest rates isn't exactly bullish for economic growth!).
Which means the reality may be that today's bond buying is not about hunting for return in bonds, but about managing the risk of equities (and/or other risk assets). Of course, if the investor really thought the popping of a bond bubble was looming, the best decision may simply be to go to cash. But given the uncertainty of timing, the next best choice for the bearish investor: stay invested, tilt the portfolio towards bonds (and likely shorten duration), and wait and see. Who knows, maybe rates will manage to go even lower from here, as they have 'surprisingly' done for the last 3 consecutive years!
For the past several years, as bond rates continue to grind lower and lower, more and more investment pundits have declared that bonds – especially US government bonds – appear to be in “the mother of all bubbles” and that bond carnage will soon be forthcoming if/when/as interest rates inevitably rise. As a result, it is often suggested that investors should reduce their allocations to bonds, and increase their allocation to stocks, which have a better expected return than the near-0% (or potentially negative return) on bonds.
Stock Valuations And Relative Rates
One of the fundamental reasons why many of those who declare that bonds are in a bubble recommend stocks are because of the relative value opportunities – simply put, why buy a 10-year government bond yielding 1.6% when you can buy the S&P 500 yielding 2%+ and get the appreciation potential of stocks from there?
Yet imagine what happens if there's a bond bubble that really does pop, and interest rates lurch sharply upwards. Imagine a world where the 10-year bond goes from 1.6% back to a "healthier" historical rate like 6%. In that environment, stocks yield 2% and bonds yield 6%. How many investors, after being yield-starved for nearly a decade, would really still hold stocks at 2% when they get could less volatile, more secure bonds at 6%? Certainly a few would, but to say the least, it would be far fewer than today... which means a lot of selling pressure.
The net result – a jump in bond rates could easily draw money out of equities, and actually accelerate the net outflows at an even higher pace than what we’ve seen for outflows in many of the past months (not to mention the cumulative 33-times-as-much money that has poured into bonds relative to stocks since December 2007), until stock prices fall to the point where equities are once again appealing when compared to a 6% yield on the 10-year government bond. Or stated more simply: a crash in bond prices and an accompanying jump in bond yields could actually cause or exacerbate a severe bear market in stocks! And in a severe bear market, the stocks could/would lose even more money than the bonds!
The Economic Impact Of A Bond Market Popping
Unfortunately, a precipitous rise in interest rates has economic consequences, too. Borrowers would face higher financing costs, which could/would slow economic activity, from residential real estate to mergers and acquisitions. Private business investment and growth would slow, as higher borrowing costs drive up the hurdle rate for making new projects appealing and actionable in the first place. Businesses and individuals that must refinance debt may find themselves cash flow constrained at higher interest rates (or unable to afford to roll over debt at all!). Not to mention the attendant economic consequences of a potential spike in the Federal budget deficit as short-term government debt rolls over into higher rates and drives up the government's interest servicing costs.
All of which suggests that if the bond market is a bubble that pops, the impact on equities won't just be one of relative value. Just as the Federal Reserve has driven rates down to help stimulate the economy, so too would a dramatic rise in interest rates slow the economy. In other words, it's hard to imagine a precipitous rise in interest rates that isn't accompanied by an economic recession. Which in turn means there's another reason why a bear market in bonds could lead directly to an even uglier bear market in stocks!
Bonds Versus Stocks - Relative Return Or Relative Risk Management?
Given the relative valuation and economic consequences that a sharp rise in interest rates would have on equities - potentially causing an even more severe loss than "just" a bear market in bonds (at least for bonds of limited duration) - it seems entirely possible that the cash flows moving into bonds in today's environment are an entirely rational decision: to invest for risk management, not just for returns.
In other words, stocks may be more appealing than bonds at current rates and in the current economic environment, but if you really believe interest rates may soon rise, you're actually forecasting that bonds will soon become more appealing - if only because they will be losing less than the stocks, especially for investors who acknowledge the risk in bonds and keep the duration relatively short.
That may not be a terribly appealing investment position - and certainly some bond investors probably fail to realize the risks and will be surprised when bonds don't merely perform as a higher-return-cash-alternative - but for investors who do want to stay invested in something and not go entirely to cash, it's still a remarkably rational choice for the lesser of two evils. And in turn, this means that as investors increasingly fear rates might rise, the pace of money flowing into bonds could accelerate further - because of the ominous sign it would bear for stocks!
Avoiding The Bond Bubble Entirely?
What all of this means is that for investors who truly fear a looming bond bubble, and want to avoid losses, the correct place to go is not equities or other risk asset classes, but to cash (or at least to drastically shorten bond duration).
The caveat, of course, is that cash yields next to nothing. Putting money there waiting for a bond market bubble to burst dooms the portfolio to a slow steady grind of inflation and negative real returns, waiting for the disaster to come, but not knowing when it will arrive. Which means, at the margin, at least getting a little yield in bonds, with a reasonably low duration and/or with an appropriate bond ladder, not knowing quite when the bond market may burst, is still relatively appealing.
And in reality, that's the purpose of the monetary policy currently being implemented by the Fed: to try to drive investment dollars to investment uses by making the return on cash so unappealing that investors will feel compelled to allocate their dollars 'more productively' (to bonds and/or stocks). Which ironically means that stocks are really only appealing as long as you think the Fed and the bond market can continue to maintain these rates, or even lower rates. If you think the bond bubble's time has come, it will be time to clear out entirely. On the other hand, sometimes the process takes far longer than most people expect. Just look at the bond market for the past several years, as many have insisted that the bond market is a bubble that will soon pop, only to see interest rates go lower. And lower. And then ever lower. Or look at Japan, which has continued to embarrass one bond bear after another for the better part of two decades.
Thus, while it's still true that unsustainable trends are, ultimately, unsustainable, it still doesn't mean today's bond investors are nuts. Perhaps they're just being savvy investors acknowledging that it's not wise to reach for return in the face of a risky environment for stocks and bonds, and instead are staying the course while playing a little defense, and avoiding the adverse consequences of just sitting in cash waiting for a day that may still be a long time coming.
(This article was included in the Carnival of Personal Finance #390 on Investing Answers, the Carnival of Financial Planning on Master The Art Of Saving, Nerdy Finance #18 on NerdWallet, the Wealth Management Carnival #8 on Marotta on Money, and also the Carnival of Retirement on Vane$$a's Money.)