TMFBro (< 20)

Is the "bond bubble" overblown?

March 15, 2011 – Comments (2) | RELATED TICKERS: AGG , BND

We keep hearing about how bonds are in a "bubble" and headed for a "crash," such as a recent article from Bloomberg entitled "The Makings of a Bond Debacle," with the subhead "Economists pick up early signs of a 1994-style bond rout in the actions of central banks."

Here's a line about what happened in 1994: "Bondholders, fearing further Fed action, sold big time. Ten-year Treasuries lost 12 percent, according to Bloomberg data, and global capital losses reached about $1.5 trillion that year."

First, a little lesson about bond math: Let's say a 10-year bond with a par value of $1,000 was issued in 1990. In 1994, it dropped 12% to $880. However, that is not a "loss" unless the investor sold. Regardless of what happened to interest rates, that bond eventually crept back to its par value as its maturity date (2000) neared, and the investor got back his/her/its $1,000 (assuming, of course, the issuer was still in business).  

"But what about mutual funds," you say. "They don't have a maturity date, so you don't know what they'll be worth at any given time." That's true, but the bonds within the funds do have maturity dates, and they will also eventually get back to par (again, except for defaults, which are rarely complete losses). Consider the Vanguard Total Bond Market Index Fund. Since its inception in 1990, the NAV of the fund has been as low as $9.13 and as high as $10.91 (which I got from eye-balling this chart), and those two numbers happened 20 years apart from each other. Not a spectacular difference for a two-decade-plus timeframe.

Or consider the Pimco Total Return Fund, the biggest in the world. It closed its first day of trading in 1996 at $10.12. Its closing price yesterday? $10.92. 

As I wrote in this month's issue of Rule Your Retirement, the real source of long-term returns from bonds doesn't come from price changes but from reinvested interest, which buys more bonds, which pay even more interest, which buys even more bonds, and so on.

But you don't buy bonds just for returns (especially nowadays, since returns are so low), but for risk reduction. They've done their job over the past few weeks. The Vanguard Total Bond Market ETF is up approximately 1.8% over the past month or so, while the S&P 500 is down about 1.8%. Investors still flock to safety when the world goes wacky.

If you can time your bond purchases perfectly -- choosing the right kind of bonds, at the right time -- then more power to you. However, market-timing with bonds is even more difficult than it is with stocks, if mutual fund data is any indicator. We know that most actively managed stock funds underperform relevant stock index funds over the long term. Well, an even larger percentage of actively managed bond funds underperform relevant bond index funds. (For more on this, check out the SPIVA scorecard.)

I don't mean to ignore the risks of potentially (nay, likely) higher interest rates. If we go through anything like the period of the 1970s through the early '80s, then even cash may fare better than bonds. Plus, interest-rate risk is just one risk with bonds; there's credit risk, inflation risk, and so on.

But even given all that, I still think that bonds are still a viable option for money you don't want to -- or shouldn't -- risk in the stock market.

Robert Brokamp, CFP®, is the senior advisor for the Fool's Rule Your Retirement service.