You may have heard market analysts commenting about the looming bond market bubble. So is there a bubble in bonds? And if so, what does that mean to you?
What’s a Bubble? When you hear the word bubble, you probably think about buying something that is incredibly over-valued and then watching it crash, along with your dreams of retirement. Over the last decade, we saw bubbles in technology stocks and in real estate values.
Bonds Are Different. But bonds are very different than stocks or real estate. Bonds are called fixed income investments because the terms of the investment are basically fixed. When you buy a bond, you can essentially determine exactly what your return will be if you hold it to maturity.
- For instance, assume you buy a new five year U.S. Treasury bond that pays 2.5 percent interest. This means you’ll get 2.5 percent interest each year for five years. And at the end of five years when the bond matures, you get your money back.
- That’s very different than stocks or real estate. When you buy stocks or real estate, you don’t know what your return will be in the future, and no one is agreeing to give you your money back.
So Where’s the Bond Bubble? Well, there really isn’t one if you buy and hold your bonds until they mature (assuming the issuer doesn’t default). The bubble language comes from the risk of lost income opportunities if rates go up.
- Some people feel interest rates are just way too low and they will have to go higher in the near future. So, if you bought a five year bond that paid 2.5 percent interest, and rates go to 5 percent for new five year bonds, you’ll be stuck holding your bond at the lower rate until it matures.
- This means you’ve lost out on the opportunity to earn an extra 2.5 percent interest for a few years. Alright, that’s a bit of a bummer, but it isn’t a loss on your investment. You’re getting the exact deal you agreed to when you bought the bond.
Changing Values. The value of bonds that you do own, however, will rise and fall with changes in interest rates. So if rates go up, the value of bonds goes down, and if rates go down, the value of bonds goes up. But that doesn’t affect the return you’ll get if you just hold your bonds until they mature. You can simply choose to ignore the interest rate price movements in between the day you bought it and the day it matures.
- You can estimate how much your bonds will move in price by using something called the bond’s “duration”. Essentially, the longer the term of the bond, the more it will move in price as interest rates change. So when rates are very low, many people tend to favor shorter term bonds, so they don’t get stuck with low yielding bonds for long periods of time if rates rise.
- You’ll need to decide for yourself how long you want to commit your money, and that will depend on your concerns about rising rates and any income needs you might have.
Traders. Those who generally lose money when bond market yields change are those who trade bonds, meaning that they don’t intend to hold them until they mature. They buy bonds at one price, hoping that the price will either go up or down based on rate changes. And if they bet wrong, they have to sell them at a loss to get out.
Bottom line. The bubble in bonds is more about the potential for lost income opportunity if interest rates rise. It’s important to have a strategy to address rising rates, but a bubble in bonds isn’t like a bubble in stocks.
As with all financial matters, consult your individual advisor prior to making any financial decisions.
