"Bonds in a bubble" - What does that mean?

junglejame911

Ok so there is a lot of chat about “bonds being in a bubble” and a lot of people are saying they would stay away from bonds. But I am confused.

Maybe I fundamentally misunderstand all of this but my simplistic understanding is that when talking about “bonds” we are mostly referring to corporate bonds or government issued bonds/gilts.

I had always thought of this essentially as a form of loan to a company/government/financial institution etc with an agreed yield at the end of the bonds lifetime. Surely if the company remains buoyant and has enough liquidity then the yield will be paid out to the original purchaser at the pre-agreed issue rate?

In this sense bonds can’t be in a “bubble” in the conventional sense – i.e. it will not burst assuming the above conditions are met. (Of course companies go bust etc and therefore may not pay out at all!).

When people refer to bonds being in bubble do they not mean that “yields are unsustainably high and future bond issues are likely to have a significantly reduced yields”. In which case those people who currently hold bonds would be unaffected?

As most of us probably don’t own individual bonds and much like shares, are more likely to invest in trusts (the ever popular Vanguard life strategy as one example) we are even more protected against individual institutions getting into trouble?

So in summary, why do bond holders need to be worried and why would they consider selling?

IronWolf

Bonds sell in the market and have an associated price. When they are issued, they will have a 'par value' usually an even number, say £100.

If they were issued at a 5% yield then they will pay £5 every year per bond.

Because interest rates are so low, investors are willing to pay much higher prices for bonds in order to get that £5 a year. So for example they may purchase a bond with par value £100 for £130.

If interest rates return to more normal levels, then the market price of bonds will also fall, as people will want a greater yield from the bonds.

You will only actually 'lose' money if you do not hold bonds to maturity, or the company defaults. But be careful of investing in bond funds as the NAV will be higher because of this 'bubble'

quotememiserable

You're (junglejamie) right in your analysis of how bonds work, but that's not where the bubble is.
Bonds (and gilts) are traded on the open market and can run well above their par value (normally £100). At the moment, there are at least two things keeping values high. QE, which is the government's money-printing scheme, which they mobilise by buying back their own gilts, creating an artificially high market. Also, a lot of pension funds are moving into fixed interest devices to de-risk because of the volatility of the equity market.

So if you were to buy bonds now, you're buying in a high market. For anyone who owns bonds an intends to hold them to maturity, the current traded price doesn't affect them at all.

bowlhead99

The bond has an initial price and a fixed interest rate to get to its final maturity. If you own one, you have certainty that you will get back that specified amount until and on maturity.

However. Bonds can be bought and sold on the open market and the value of a bond today reflects its desirability. I'll simplify the rest of the explanation:

Say a 1000 pound bond from Company A is issued at 10% and it's going to deliver that 10% year in year out for a couple of decades.

In the grand scheme of things, because who knows what the 1000 will buy in 20 years time, the focus is on the recurring annual income, which is a hundred quid.

Now with interest rates at historic all time lows (a UK 10-year gilt is yielding under 2%), companies these days are never going to offer 10% interest rates. Maybe 3% is the current going rate for a company of equal risk (call it company . So Company B issues its 3% bond at 1000 quid and it pays 30 a year.

Now you are holding the Company A bond which is giving you 100 every single year. No way your Company A bond is 'only' worth 1000. You'd have to buy 3333 quid worth of Company B bonds to get the same recurring annual income. Naturally, the market price of Company A's bond goes through the roof. The fact that government is printing money like crazy and buying bonds, and everyone is scared of equities, contributes to the high prices.

So lets say someone who wants a mix of bonds and equities in his portfolio goes and buys some bonds at today's prices. He pays a bit more than 3k for a basket of bonds yielding 3% (100 quid p.a.)

Then interest rates go back up to more normal levels in a year ot two and the government's stimulus activity as a buyer of bonds in the market ceases and equities seem less risky as economy improves. All of a sudden, the market average is for bonds with a risk level of Company A or Company B to yield 6% not 3%. Someone won't pay you 3k+ for your bonds to only get back 3% a year and when they may have a low nominal value at maturity. The bonds will fall in value horribly until the yield works out to the right level for the market.

I would only want to pay enough for your bond to achieve my normal market yield of 6%. I can't pay 3000+ for something that only pays 100 a year. I will only pay maybe 1600, 1700. If you bought, or were holding, at 3000+, you'll be somewhat disappointed to still be holding at 1700.

So while you can buy short-dated individual bonds which mature in 4 or 5 years and know exactly what you're getting as you hold it to maturity, it can be quite dangerous to go out today and buy a bond fund or a gilt with a very low yield, as these will fall in value when changes in interest rates and inflation make them relatively less desirable.

By the same rationale, if you own a bond already, you could consider selling it and cashing in at an all time high price rather than waiting for an eventual payback. A 1.92% yield on a government gilt is negative in real terms and though equities are also much more expensive than a couple of years ago and can reduce in value, they generally grow over time and the dividend stream is somewhat inflation protected in that it will grow with the company's profits.

[Edit : I should type faster or write more concisely, as the other posters got in there first with the right answers! ]

redbuzzard

quotememiserable wrote: »

You're right in your analysis of how bonds work, but that's not where the bubble is.
Bonds (and gilts) are traded on the open market and can run well above their par value (normally £100). At the moment, there are at least two things keeping values high. QE, which is the governments money-printing scheme, which they mobilise by buying back their own gilts, creating an artivificially high market. Also, a lot of pension funds are moving into fixed interest devices to de-risk because of the volatility of the equity market.

So if you were to buy bonds now, you're buying in a high market. For anyone who owns bonds an intends to hold them to maturity, the current traded price doesn't affect them at all.

True, but they could end up with a choice between taking a capital loss now, or staying invested for years into the future at low returns.

Pension funds of course often buy bonds to hold to maturity - it's how they "fully fund" with liability matched investments. But locking in to low yields is expensive.

Pension funds sometimes have strategies for skimming off strong equity performance into bonds too. That is looking questionable when the downside risk on the bonds may be no better than the equities they replace.

Shaolin_Monkey

junglejame911 wrote: »

When people refer to bonds being in bubble do they not mean that “yields are unsustainably high and future bond issues are likely to have a significantly reduced yields”. In which case those people who currently hold bonds would be unaffected?

Actually it's more the opposite - yields are very low compared to long term historical levels. Yields on bonds fall as the price rises and vice versa. Furthermore, bonds where there are greater risks, like emerging market debt and high yield bonds have had their yields pushed down to levels investors may not be getting much return for the risk they are taking on.

As already explained when a bond is first issued it is for a nominal amount like £100, and pays interest at an agreed rate (aka the 'coupon'), and usually has an agreement to repay the principal £100 at a date in the future. These bonds are then traded in the secondary market and their price rises or falls depending on various factors.

Some of the factors include:

- Central bank interest rates (how much interest you can get by simply depositing cash in the bank)

- The perceived credit risk of the bond (i.e. how likely it is investors will get their money)

- The remaining term of the bond (longer duration bonds tend to be a lot more volatile than short duration bonds, and more sensitive to interest rate changes)

- Central bank intervention (QE).

- Market sentiment (during 'risk on' periods investors are more likely to sell bonds to invest in riskier, higher return assets like equities)

The prices on the secondary market influence how much institutions have to pay as a coupon on any new debt issues.
For example, there was a lot of concern when Italian bond yields spiked sharply recently (due to perceived increased credit risk). This effectively meant that when they had to go to the market to borrow more money (which governments have to do on a regular basis) they had to pay a much higher coupon than they'd like, and there was concern that they would have to be bailed out.

I don't think many informed commentators are recommending cutting all bonds from portfolios. It is after all important to diversify investments across different asset classes. But it is probably wise to be selective about what bonds you are holding. I think the main worry is that interest rates can only now go in one direction. Maybe not in the short term, but if/when a sustained recovery takes hold, then QE will likely be history, and interest rates will creep up. This will cause bond prices to fall and yields to rise. Longer duration bonds are said have greater interest rate sensitivity and so they will fall in price much further if interest rates trend upwards.

Personally I currently prefer funds with a more flexible mandate (like strategic bond funds) with a bias to shorter dated bonds. Tools like Morningstar fund screener allow you to search for funds with different characteristics, including interest rate sensitivity.

Of course all of the above is a personal view as a private investor, I'm not an expert....

junglejame911

Thanks for all the replies. Makes much more sense.
So can bonds fall below the original par value or is your capital only at risk if you buy at some point during the lifetime of the bond and at a higher price? (thus risking a fall).


This certainly does have implications for people holding “funds” of bonds as presumably you are not necessarily buying at issue (nor selling at maturity).

Just read Shaolin Monkey's reply as I was posting! Thanks

quotememiserable

junglejame911 wrote: »

Thanks for all the replies. Makes much more sense.
So can bonds fall below the original par value or is your capital only at risk if you buy at some point during the lifetime of the bond and at a higher price? (thus risking a fall).

They can fall below par, but you still get par value if you hold to maturity. As you say, you only lose capital if you sell when the price is below what you paid

junglejame911 wrote: »

This certainly does have implications for people holding “funds” of bonds as presumably you are not necessarily buying at issue (nor selling at maturity).

Quite right, the fund varies with current prices and bond fund unit prices can rise and fall

kidmugsy

Beware - bond funds have entirely different characteristics from bonds themselves. With a bond you know when it will mature, how much capital you'll get back on maturity, and the income you'll get in the meantime. Not so for funds.

gadgetmind

junglejame911 wrote: »

So can bonds fall below the original par value

Yes, particularly those with a long duration and/or where the institution is seen as high risk.

For instance, the Co-op bank is currently teetering a little (as did Greek and Irish banks a while back) and one way for them to shore up their capital base is to use various methods to give their bondholders a haircut. Their bonds and preference shares are therefore trading well below par, and thus on very high yields.

I have bought into distressed bonds and prefs in the past, and have done very well from it, but it does tend to feel like picking up pennies in front of a steamroller!

quotememiserable

redbuzzard wrote: »

Pension funds sometimes have strategies for skimming off strong equity performance into bonds too. That is looking questionable when the downside risk on the bonds may be no better than the equities they replace.

Indeed, many pension funds now operate a flight path where they switch to bonds and gilts (but mostly bonds at today's prices) when equities hit certain trigger prices, to capture those gains. They only do this where they plan to hold the bonds to maturity to match their liabilities though, so I don't think the downside risk on the bonds is an issue.