Of bonds and bubbles (and a bubble in calling things bubbles)


People are determined to not look stupid again. So the “smart” thing to do these days in the post-crisis world is to be the most pessimistic guy in the room…the attitude being ‘everyone else is too naive to understand what lies ahead!’ People are becoming the people they wish they had been in 2007 and it is the guy who sounds the smartest about all of the risks that now gets all the attention.

A recent example of a nouveau bubble spotter is Ross Sorkin (of the New York Times and CNBC) who recently asked Lloyd Blankfein (CEO of Goldman Sachs) whether corporate bonds are in a bubble. Clearly, Mr. Sorkin was either suggesting that he thinks bonds are currently in a bubble or that they are heading there. He may also strategically wants to be on the record for being an advanced thinker or may simply be practicing media sensationalism. Mr. Blankfein’s answer, did not acknowledge a current or looming bubble, but did say it is a great environment for corporations to raise debt. The point of this essay is the question not the answer.

Here are my thoughts…

There are miles of mispricing and irrationality between assets being merely dearly priced, with poor prospects for returns ahead, and an actual bubble. Bubbles are extremes. Bubbles ruin people. When bubbles pop, their popping reverberates throughout financial markets. Though bond interest rates are at historic lows and retail investor cash flows have been net positive for bond mutual funds and negative for the equity variety, there has been no evidence of:

  • massive and ever-accelerating swell in bond ownership
  • dangerous levels purchased with borrowed funds
  • imminent risk of historic default levels by the issuers

In other words, the symptoms of a looming bubble are not present. In fact, most still describe corporate balance sheets as healthy, with less debt and more cash than has been the case for many years. CEO’s, as a group, are positioned for a low GDP growth environment, and investors by and large are postured defensively–even the most amateur of investors are well versed on the current macro risks (Europe, US Fiscal Cliff & debt ceiling, slowing growth in China, etc.). Furthermore, risk averseness is having its own bull market. Sounds like sandy rocky soil for a bubbles crop to me, and I do not think we are close to seeing Flipping Bonds on a cable channel anytime soon!

The irony is this–all of the fear by investors of another 2008 makes it nearly impossible for another 2008 to actually happen. So when the fear is the highest, the risk of a catastrophe is the lowest! 2008s only happen when fear is wrung out of the market and investors stay awake at night worried that they are making less than everyone else.

Back to bonds and bubbles

No question that an investor in 3% coupon 10-year investment grade corporate bonds may regret that purchase if in a few years similar bonds offer 5% or 6%, and the market value of her bond portfolio will go down enough to turn the 3% coupon into a 6% yield to maturity. But if held to maturity, the investor gets her principal back, so the bonds gradually re-price back to par as the maturity date approaches. Thus the risk (besides outright default) is that the investor is a forced-seller of her bond portfolio when rates are at 6% and she sells at a ~15% loss of principal. But even that is not so bad if, for example, in year five the investor already received 15% of her principal back in previous years’ interest payments (5 years * 3% coupon), so she still has not lost any capital.

As the result of that I do not foresee any government bank bailouts and investment bank failures. I do not foresee aggregate individual net worth going down by 50% (which happened 2007-2009). Especially since the most likely reason rates begin to go up is because there is finally a pick-up in economic growth, so the portion of individuals’ net worth tied to equity markets and home value will be increasing. I do not foresee unemployment going back above 10%. I do not foresee, in other words, any of the catastrophic outcomes one would expect from a collapsing bubble.

More generally, the likelihood is very low that any of the current known global risks can cause a 2008-like market collapse—there is simply not enough risk in the system for that fire to catch and spread.

So let’s all be skeptical, at all times good or bad, about what we hear from the media, from the experts and from our friends. We at A Street Investments will do our best to take our own advice for the benefit of us all.

Final note:
Bonds are indeed expensive relative to historical averages in terms of both yield and spread (spread is the difference in yield relative to Treasury securities). I believe we are in an environment that favors active management. I want my money in the hands of portfolio managers experienced and skilled in risk management–those who make thoughtful decisions with regard to duration, sector exposure and credit risk. I believe fixed income assets, even at current yields, play an important role in diversification and will potentially be a hedge against various downside scenarios that would be negative for the other parts of our portfolio.

** The opinions expressed in this article are for informational purposes only and should not be construed as investment advice. The article is not a recommendation of, or an offer to sell or solicitation of an offer to buy, any particular security, strategy or investment product. The research for this article is based on current public information that we consider reliable, but we do not represent that the research or the report is accurate or complete, and it should not be relied on as such. The views and opinions expressed in this article are current as of the date of this article and are subject to change.