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How the Market Works

The Bond Bubble

Posted by kdadmin on July 31st, 2015.

The Bond Bubble

I’m not a big fan of the word, “bubble,” because it creates hysteria in the minds of amateur investors. But it seems to be all the rage these days, especially in the bond market. From former Federal Reserve Chairman, Alan Greenspan, to billionaire investor Carl Icahn, to the “Bond King” Bill Gross; each of these experts has weighed in with their concerns about a bond bubble.

Lucy, you’ve got some ‘splaining to do …

Here’s how the market works:

  1. As bond yields go up, bond prices go down. Think of it this way:
    1. If you own a $100 bond that is paying 3%, but then interest rates go up to 4%, your bond becomes less valuable because everyone else can get 4% on their money instead of your 3%.
    2. So, the price ($100) of your bond would go down if you wanted to sell it to someone else because they would expect a 4% yield.
  2. Bond prices are usually a function of credit quality, interest rates and perceived stock market risk.
  3. Bonds, like stocks, are usually considered a long term play, not a short term speculative one.

Thearguments for a bond bubble include:

  1. The Federal Reserve has been artificially stimulating the bond market by buying billions of dollars of bonds each month from 2009 to the end of 2014. They’ve stopped.
  2. The Federal Reserve is expected to raise interest rates in September. (Rising rates = falling bond prices.)
  3. With high demand, bond prices have gone up much more quickly than they normally would. Speculators see this as an opportunity to make a short term profit and begin trading bonds as they would stocks. This causes remarkable volatility in a more commonly staid market. Just look at TLT (a 20 year treasury bond ETF) in the chart above.
  4. Oil companies borrowed billions of dollars in junk bonds (low credit quality, here represented by the ETF, JNK) to fund their fracking operations when oil was $100/barrel. But now, with oil down 50%, the chance of these bonds defaulting increases substantially. And it shows. JNK has dropped over 7% this year already

I’ve used AGG to represent the mid term high quality bond market ETF; which has been flat to 2.5%.

But the real story is in the red line. This line represents the change in Baa Corporate Bond Yields. In other words, the change in yield on non-government, non-junk bonds. Notice how this line seems to
operate inversely with JNK and TLT? Notice how it’s taken a sizable jump in the last three months? Remember that rising yields mean dropping prices?

So, what does this mean? There is merit to the bond bubble theory. Especially given the potential for a surprise in the amount of the interest rate hike in September. Or, more to the point, it supports:

  1. Why we sold our high yield bonds over a year ago.
  2. Why we did NOT buy TLT when it was in fashion in January. Read my blog post about that.
  3. Why it’s unlikely that we will maintain our other bond positions much longer.

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