Practical analysis for investment professionals
25 August 2016

Is There a Bond Market Bubble?

What is a financial bubble?

A financial bubble occurs when the market price of a security or a group of securities increases well beyond the point where the long-term benefits of ownership fail to compensate the investor for the costs — market price, trading costs, liquidity, etc. — and risks of ownership.

Which brings us to the bond market.

If the results of a recent CFA Institute Financial NewsBrief poll are any indication, at least some of the global fixed-income market is in bubble territory. So if respondents agree with the above definition, then 87% of the 815 participants believe that owning at least some types of fixed income no longer makes sense.

Yet clearly many investors do own these bonds. What explains this dissonance?

The global policy response since the financial crisis of 2008 has been massive and unrelenting. While the US Federal Reserve has (at least for now) ceased its quantitative easing (QE) operations, it has struggled to return interest rates back to normal levels or reduce its balance sheet back to its former size. Japan has maintained QE at approximately 15% of its GDP for some time, and recently hinted that it may escalate it in the near future. In March of this year, the European Central Bank (ECB) increased its QE program from €60 billion to €80 billion in bond purchases per month.

All of this bond buying by central banks has been intentional, of course. By providing a bid under bonds, they have lifted bond prices and reduced interest rates. In many cases, like in Europe and Japan, this has created negative interest rates. The ECB now “charges” a negative interest rate of 0.4% for banks that borrow from the ECB. Of course, this means that the ECB is actually paying banks to borrow money.

In July, Germany became the second G7 nation to issue a 10-year bond with a negative yield. In fact, according to a recent report by Bloomberg, more than 80% of German government bonds have negative yields. In Japan, 20-year bonds are now below zero. This is making it hard on global bond fund managers where Japanese bonds typically comprise 20%–35% of the global bond indices. (How would you like guaranteed losses on one-third of your holdings?)

Globally, over $13 trillion of the global bond market is now negative. “It’s surreal,” says Gregory Peters of Prudential Fixed Income.

Of course, this backward, underwater, upside-down world is just fine with some people. Certain investors suggest that negative yields are a “Sign of Prosperity.” And some bond managers have even figured out clever ways to make money in this market. For instance, PIMCO is buying negative yielding Japanese bonds and using swaps to lock in exchange rates, effectively quadrupling the yield on long-only US bonds of similar duration. So, they are buying negative yielding bonds, but using savvy finance skills to transform it into positive yield.

And that’s really the game, isn’t it? Low and negative rates are forcing legions of investors to seek higher yield, and in doing so, they are taking on more and more risk. Maybe it’s because they know that the central banks will maintain these policies despite potentially adverse consequences in the long term.

So, what do CFA Institute Financial NewsBrief respondents make of the fixed-income market today? As noted, 87% of respondents see the bond market in bubble territory in some way. In other words, they believe that bonds today fail to compensate investors for the costs and risks of ownership.

Are any of the following global fixed-income markets in bubble territory?

Are any of the following global fixed-income markets in bubble territory?

The largest segment of respondents (30%) believe all bonds are in bubble territory. Another 24% see a bubble in sovereign bonds and at least one other class of fixed income, while 14% of poll participants think that only high-yield bonds are over-inflated. When combined with other classes of bonds, 54% of respondents view high-yield bonds as in bubble territory. And roughly 13% don’t see a fixed-income bubble anywhere. Perhaps this cohort should have attended the Financial Analyst Seminar in Chicago where Edward Altman suggested that “the benign credit cycle is in ‘extra innings‘” — an ominous sign of a coming default cycle.

Most investors recognize the vast power that central banks wield but, by and large, disagree with the wisdom of their policies. In order for the world to return to market pricing of bonds, there has to be a catalyst. The power of the central banks must be more than offset by something else. There has to be a fundamental wave — either positive or negative — to counteract it, or a political wave to change it.

Until then, investors will remain adrift on an ocean of negative yields.

Editor’s note: An earlier version of this article did not specify that 815 respondents participated in the poll and stated that “only 14% of poll participants think high-yield bonds are over-inflated.” That was incorrect. It now reads ” . . . while 14% of poll participants think that only high-yield bonds are over-inflated.” Also, an earlier version did not specify that Germany was the second G7 nation to issue negative 10-year bonds. It did so in July.

If you liked this post, don’t forget to subscribe to the Enterprising Investor.

All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

About the Author(s)
Ron Rimkus, CFA

Ron Rimkus, CFA, was Director of Economics & Alternative Assets at CFA Institute, where he wrote about economics, monetary policy, currencies, global macro, behavioral finance, fixed income and alternative investments, such as gold and bitcoin (among other things). Previously, he served as SVP and Director of Large-cap Equity Products for BB&T Asset Management, where he led a team of research analysts, 300 regional portfolio managers, client service specialists, and marketing staff. He also served as a Senior Vice President and Lead Portfolio Manager of large-cap equity products at Mesirow Financial. Rimkus earned a BA degree in economics from Brown University and his MBA from the Anderson School of Management at UCLA. Topical Expertise: Alternative Investments · Economics

19 thoughts on “Is There a Bond Market Bubble?”

  1. David Olson says:

    You have already said it.
    The most likely outcome will be a wave of defaults and a large scale decrease in the amount of money and in personal wealth.
    (– Personally, I think that the best current investment for most ordinary people is in job skills and job seeking skills. …
    … The people who are investing in land, gold, firearms and ammunition are ‘going over the top’, in my opinion…)

    1. Thanks for your comments David!

  2. Josh Brown says:

    It’s all part of a global currency reset in order to devalue long term debts in aging western nations. Round robin currency devaluations … whose turn is it now? Has the music stopped yet? This will not end well.

    1. Thanks Josh! We all seem to know that something is awry, but getting the timing right is another matter entirely. Like the old Tom Petty song, “the waiting is the hardest part…”

  3. David Maywald, CFA says:

    Hi Ron, can you please share a bit more detail on the poll results? (number of respondents, when it was conducted, info on the sample of ppl that it comes from, etc)

    Can you point to other surveys, market pricing, betting odds, or similar that confirms the poll results?

    1. Hi David,

      Very good questions. The poll was conducted on Tuesday and Wednesday of last week (23 & 24 August, 2016). There were 815 respondents and they are simply NewBrief readers. Unfortunately, we do not have detailed breakdowns of their characteristics, nor summary statistics for the cohort to confirm whether or not they represent the markets as a whole. Lastly, we do not have other surveys to compare with ours. Hope this helps. Thank you.

      1. David Maywald, CFA says:

        Many thanks Ron 🙂 This is a valuable contribution to one of the big financial market issues of our time… Cheers, Dave

  4. Franco says:

    The graphic presentation lends itself to misinterpretation. For example, the article states that “Somewhat surprisingly, only 14% of poll participants think high-yield bonds are over-inflated.” Actually, 54% thought so. That is, one must account for those who thought only high-yield bonds were in a bubble (14%), plus the “A and B” responses (5%), plus the “A and C” group (5%), plus those who thought all categories were in a bubble (30%).

  5. Franco, you raise a valid point. It should read “14% of poll participants think that ONLY high yield bonds are over-inflated. When combined with other classes of bonds, 54% of respondents view high-yield bonds as in bubble territory.” Good catch!

  6. Genghis says:

    The survey forces a yes/no answer. The survey would have been more valuable if “I don’t know” was an option to the question “Are any of the following global fixed-income markets in bubble territory?” My guess is that a large percentage of respondents who were forced to say yes to the question would have selected “I don’t know.”

    1. Alban Roger says:

      Germany was not the second country to borrow at negative 10-year yields:
      – Japan was indeed the first
      – Switzerland already @ -0.60% at the time and had gone negative months before Germany
      – Denmark was negative in July

      “Yet clearly many investors do own these bonds”:
      Not that many in % of outstanding negative-yielding debt as their main holders are central banks that were their buyers before they turned negative-yielding.

  7. Dan says:

    So Stocks are high and Bonds are over inflated, were do cautious investors run and hide from the boogey inflation man?.

    1. David says:

      IMHO, it is not inflation that you and I have to worry about, it is…
      *) the risk of a decline or market crash … or
      *) the risk that there simply won’t be any returns to putting your money in, near the top. (referring to above, that includes Will Rogers’ “return of my money”.)
      — — the long ‘sideways’ era. With downside risk. — —

  8. Spencer says:

    The bond bubble finally bursts in 2017 – as inflation accelerates but R-gDp decelerates.

    p.s. I am the greatest economic and market timer in history.

    1. Bobby Gould says:

      Spencer please be right. I tell my wife all the time (regarding my short positions on stocks, bonds and commodities), “I may be early, but I’m not wrong.” by Michael Burry in ‘The Big Short’

  9. Pingback: AAII Blog
  10. Dennis Albrecht says:

    Does anyone have a idea when things are going to get real bad like 2008-09?

Leave a Reply

Your email address will not be published. Required fields are marked *

By continuing to use the site, you agree to the use of cookies. more information

The cookie settings on this website are set to "allow cookies" to give you the best browsing experience possible. If you continue to use this website without changing your cookie settings or you click "Accept" below then you are consenting to this.