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I’m Afraid of a Bond Bubble

Karl writes in to ask,

“The old ‘age in bonds’ rule would have me put approximately one fourth of my portfolio in bonds. But I’m reluctant to put anything in bonds because I’m afraid that bonds (Treasuries especially) are in a bubble much like tech stocks in the late 90s. Assuming the bubble pops and interest rates come back up to more normal levels, bond prices will fall, right?”

It’s true, of course, that interest rates are very low right now. And it’s true that when rates come back up, bond prices will fall.

But Stocks Are Still Riskier

If risk of loss is what you’re concerned about — and saying you’re afraid of a bubble suggests that’s the case — then moving more money into stocks doesn’t make one bit of sense. Even with interest rates at historical lows, stocks are still riskier and more likely to have a large drop in price at any given time.

For example, from its peak in 2007 to its trough in 2009, Vanguard Total Stock Market Index Fund fell approximately 50%. For Vanguard’s Total Bond Market Fund (with an average duration of 5.1 years) to fall by that much, market interest rates would have to increase by almost 10%. In other words, interest rates would not just have to come back up to normal levels, they’d have to go shooting far beyond that.

And if you decided to stick with a short-term bond fund, the risk of significant loss due to a rise in interest rates would be even smaller.

Asset Allocation Based on Risk Tolerance

If the idea of incurring a significant loss in your portfolio really scares you, you need to be thinking about limiting your stock allocation.

My own personal favorite rule of thumb for asset allocation is to spend some time thinking about your maximum tolerable loss, then limit your stock allocation to twice that amount — with the line of thinking being that stocks can (and sometimes do) lose roughly half their value over a relatively short period. For example, if the idea of a 30% decline really scares you, I wouldn’t go higher than 60% stocks.

As far as your bond allocation, if you really are convinced that rates will be increasing soon, using a relatively short-term bond fund will minimize your exposure to interest rate risk.

I’d add the caution, however, that just because rates are low right now doesn’t necessarily mean they’re likely to be increasing any time soon. And by sticking with shorter-term bonds, you’ll be earning a lower rate of interest while you wait for rates to come back up.

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  1. What you said is very true. However, the total bond index has a yield of less than 2.5% right now while CPI just hit 3.9%. Bonds with shorter duration are almost guaranteed to lose money after inflation, so people with high maximum tolerable loss and want real long term returns should have less than their age in bonds.
    Personally, I have more money in I-bonds than regular treasuries because I-bonds have short/variable duration and keep up with inflation. However, I regret not having more long term treasuries since I cannot sell I-bonds to rebalance.

  2. I am too concerned with a bond bubble – or maybe bubble is too strong but it is certainly reasonable to assume that rates will eventually have to rise.

    If you are a long term investor, and have no need for the money for at least 20 years… Does it make sense to own short term bond funds? I’ve talked to Vanguard CFAs and they’ve encouraged to settle on Intermediate term b/c if rates go up, nav will go down but yield will also increase. So in the end, if you endure the nav drop, you will (hopefully) come out ahead after 10 years.

  3. Investment risk is more than just short-term volatility. Long-term investors care about the risk of not meeting their investment goals.

    I’m in TIPS and Stable Value and Short/Intermediate (not Long) Term bonds on the fixed income side because the Bond Bubble seems like a credible threat to me.

    At the risk of sounding harsh or simplistic, it seems to me that an Oblivious Investor must either be an Ostrich or a Skeptic. To suggest that a Bond Bubble can’t really exist because stocks have always been more volatile than bonds sounds like how an Ostrich might make their case.

    Mike, have you ever read Michael Lewis’s The Big Short: Inside the Doomsday Machine? It’s a story of how some unconventional characters become increasingly skeptical of the wisdom of the subprime mortgage market, and realize that this crooked house of cards must collapse, and that incredibly they’ve stumbled upon a once in a lifetime chance to make huge money betting against this toxic bond bubble.

  4. Dale,

    Yes, I’ve read The Big Short.

    I don’t think I ever “suggested that a bond bubble can’t really exist.”

  5. Mike, if you frame stocks as always being riskier than bonds as a reply to someone expressing their fear of a bond bubble, it seems to me that you are minimizing if not effectively denying any unusual risk of a bond bubble.

    Not willing to conjecture that the market already efficiently prices in any unusual risk?

  6. I don’t know what to say other than, I disagree. I’m not denying the existence of a bond bubble. I still think stocks are far riskier (at least as measured by probability of a significant loss over a relatively short period) than a typical “total bond market” type fund.

    To use the example from the article: Which would you say is more likely to lose, say, 30%, 40%, or 50% over the next year: Vanguard Total Stock Market Index Fund, or Vanguard Total Bond Market Index Fund? I wouldn’t hesitate to say the stock fund is more likely to have a loss like that.

    A “bond bubble” popping would mean what? Personally, I would think it means interest rates suddenly coming back up to historically normal levels. If that happens, we’re still not looking at a loss of that degree for a Total Bond Market fund with a 5-year duration.

    In addition, with bonds you at least know that if you hold them to the duration, you’ll get back your original value (default notwithstanding). With stocks, there’s no such certainty at all.

  7. We all agree with you on *that* risk, Mike. I think it’s just that we’re concerned about a different type of risk: perhaps the risk that owning our age in traditional bonds this decade makes our being able to retire as planned less likely instead of more likely.

    Everyone commenting here seems to be hedging that bond bubble risk by avoiding long term bonds, at least. TIPS and I-bonds have also been mentioned as inflation indexed alternatives to traditional bonds. Are there any other viable countermeasures to consider when several years of rising inflation seem fairly likely not too far down the road?

  8. Mike, what you have written is true, a bond fund with an average duration of 5 years is almost as low risk as cash. Given that there are checking accounts, CDs, and I-bonds that yield more than 5 year treasuries, it does not make sense to hold short term bonds and take uncompensated risk. Long term bonds, on the other hand, ARE risky. If the US gets into Italy or even France’s situation, 30 year treasuries can lose even more value than stocks. Investing is all about being compensated for risk, and I don’t think either long or short term bonds are doing that. (Your response to this, of course, would be that the market is efficient. However, when half of treasury holders are the Fed, foreign government stockpiles, social security, and other entities not interested in being compensated for risk, is the market really efficient?)

  9. Depends on your time frame. Stocks underperformed during the past decade, but those in blue chips earned roughly what bondholders did when dividends were included. Over time, however, stocks beat bonds and other instruments hands down, even when you include the bear markets.

    For over a hundred years now, stocks have returned around 11% on average, whereas bonds earned between 5-6%. For long term investors, that makes a huge difference and can mean the difference between retiring in a 10-foot camper trailer or a big house on a lake.

    My .02

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