Articles | The Weekly Acorn
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Bonds: The Next Bubble?
Whenever you find yourself on the side of the majority,
it is time to reform (or pause and reflect).
- Mark Twain, 1904
IIn the early '80s it was real estate. In the late '90s it was stocks - especially "dot com" stocks. Most recently, it was real estate again. The IT of course, was a bubble, and like all bubbles eventually do, they popped.
And when they popped, almost everyone was surprised. Why? Because very few people recognized the bubbles for what they were. Most folks considered the bubble de jour to be the new paradigm - the new reality.
On the other hand, you have the perpetual pessimists who see bubbles everywhere and are constantly warning us to watch out for them. And every so often, their predictions of doom come true, as they are bound to, and then they are hailed as the new sages of the era. In truth, they are more like broken watches: wrong, except twice a day.
The reality is that investment bubbles are easy to identify (in hindsight). We look back and say, "Yeah, I should have seen that one coming. I'll be on my guard and won't miss it the next time." Right. The problem is that the "next time" it will be something different, something unexpected, and we'll likely miss that next one also.
That said, there appears to be an investment bubble forming on the horizon that we should be paying attention to, and that is "bonds"; particularly, government bonds (the very same bonds that for many, many, many years have been the very definition of a "risk free" investment).
But, how, you rightly ask, can a bubble form around an asset that is essentially risk free? The answer lies in understanding how a bubble forms in the first place. It starts when people desire to have something so much that the price really doesn't matter anymore. If enough people get that attitude, then the price of whatever it is will go through the roof.
And so it is with bonds today. Investors are so shell-shocked from what they endured in stocks and real estate in the last decade that they have decided that they have had enough. They are tired of losing money, and don't want to lose another nickel, ever. But investors are also unwilling to accept today's historically low interest rates on savings accounts and CD's and they feel that the only thing left is bonds, and have been turning to them in record numbers. And all that seems to matter is that the investment is a "bond" (translation: safe) and that it is paying at least a little more interest than they are getting at the banks. The result is a virtual bubble incubator.
Now, the technical details of just what makes bonds so risky right now is a little beyond the scope of this Acorn, but it has to do with the inverse relationship between bond prices and interest rates. When interest rates decline, prices go up, and when they rise, values drop. And lately, the demand for bonds has driven interest rates to about as low as they have ever been, and as we like to say around here, ever is a very long time.
To put this in perspective, the current interest rate on 10 year treasury bonds is about 2.6%. That means that investors are willing to lock up their money for 10 years and settle for a 2.6% return for that period. The mentality seems to be that "it beats a sharp stick in the eye", which it undoubtedly does, but the investor may end up with the sharp stick anyway. If interest were to rise a mere 1% from the current rates, the value of the 10 year bond will decline by over 8%. And if interest rates go higher, the bond values will go lower still. So what was thought to be safe will turn out to be anything but.
Needless to say, we at Charter Oak are paying serious attention to this and have already taken some steps to protect portfolios from this new bubble. If you have questions about this or would like to discuss your particular situation, please call our office to schedule a one-on-one.
Sincerely,
The Charter Oak Team
