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Re: Coming Catastrophe in Bonds



February 05, 2013 – Comments (5)

This blog is in response to a blog posted by TMFPostOfTheDay on February 1st called.

"Coming Catastrophe in Bonds?"

Overall it was a great blog.  However in the comment's section  MegaShort and  somrh had some very valid questions. 

  "Is the possibility of intermediate term bonds losing 3% in a year really that bad compared to the possibility of stocks losing 30%?" - Megashort


"but that makes me wonder why he's choosing to hold cash which has an even greater real loss." - somrh

I agree with the author as I am one of the many people who have been calling a bond bubble for years now.  Is it possible that this bubble could never pop? Of course.  I would actually prefer that it didn't.  But it case it does, it doesnt hurt to be prepared. 

Now of course I arrive to the party after everyone has already cleaned up.  So I replied to these questions but I doubt any of these people will get a chance to see it on the original post so I will repost it here: 

  Well if the bond bubble pops as many are predicting it will, we are looking at losses to the tune of 30% and up.  Also interest rates will simultaneously skyrocket to levels unseen by many.  It will be the 2008 crisis 2.0 and it will be much harder to recover from.  If we were only looking at a loss of 3% a year then thats hardly a crisis at all.  But thats not what we're talking about here.  We are looking at bonds selling for practically pennies on the dollar. That in and of itself could destroy retiree income.  The implications are far reaching and dire.  So preparations need to be made to reduce exposure to bonds as much as possible.  As the author said, stick to short term bonds. There is just too much downside risk in long term.  Cash is king because there will be opportunties galore when the bond bubble pops.  Stocks are an ok alternative, but I have a feeling that in the event of a bond collapse, commodities will skyrocket.  So one should seek to increase exposure there, at least in the short term.

But thats just my two cents. 

5 Comments – Post Your Own

#1) On February 05, 2013 at 2:06 PM, somrh (81.16) wrote:

There's a few issues that need to be addressed.

1) As Megashort pointed out, the thesis of the bond bubble or bond catastrophe wasn't spelled out. 

Here's a good article that I think does a good job of questioning the bond bubble thesis.

2) If we're talking about higher interest rates in the future, which would mean lower bond prices, then that's definitely something that could occur.

The author of that article, however, was wrongly claiming that this is a permanent loss of capital when, in fact, it's only an opportunity loss of capital. As I pointed out, if you buy a bond today that has a yield to maturity of 3% and you hold to maturity you'll earn 3% (provided there's no default).

It could turn out to be a volatile ride but it isn't a permanent loss of capital.

3) Now you point out retirees and I think that's an issue. But I don't see that as a "bond bubble" issue so much as an asset-liability management (ALM) issue. 

If I need money for something, say, in 5 years, then I shouldn't be investing in stocks or 30 year bonds. I need the money in 5 years, so I should be using  shorter-term assets that match my liabilities. 

So I think that's relevant but not because of a bond bubble.

As a side note, if I had to make a prediction I would guess interest rates could stay low for quite some time. But if you match assets and liabilities you don't really have to make those kinds of guesses. If you have some insight into future interest rates, you can play tactically and attempt to profit off of that insight. For those that don't have some special insight, ALM is the way to go. 

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#2) On February 05, 2013 at 4:42 PM, ChrisGraley (28.49) wrote:

The municple bond bubble scares my more and I think it will act as a catalyst for the general bond market.

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#3) On February 05, 2013 at 8:01 PM, rd80 (94.59) wrote:

I think long term bonds at these levels are every bit as risky as blue-chip stocks. 

Year-to-date, Vanguard's LT Gov Bond ETF (VGLT) is down from 74.49 to 72.51, a loss of about 2.6% in just over one month.  Granted, that is a long-term bond fund.  However, it isn't a 2x or 3x fund or something using crazy levarage.  I suspect an awful lot of bond investors have no idea a run-of-the-mill, plain vanilla bond index fund can lose nearly 3% in just over a month.

I agree that anyone holding individual bonds to maturity only faces an opportunity cost (still a real cost), barring default, if rates rise.  But, most individuals hold bond funds where the losses can be permanent - if existing investors sell off shares, the fund has to sell holdings and locks in losses for everyone.

No position in VGLT.


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#4) On February 06, 2013 at 12:13 PM, constructive (99.96) wrote:

"A bubble means that people are buying an asset at ever-rising prices for speculative reasons, not for the fundamental value of the asset but because they are assuming somebody else will buy it at a higher price. I see no evidence of this behavior by buyers of Treasury bonds."

Perhaps he doesn't see the evidence because he's not looking for it?

The average annual turnover for intermediate government bond funds is 211%, and now ultra bond ETFs are available for even more speculation.

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#5) On February 06, 2013 at 4:47 PM, somrh (81.16) wrote:

@ MegaShort

I've always been curious about the turnover rates for bond funds. I've read everywhere (skeptically) that bond funds, even passively managed will tend to have higher rates. So I'm wondering how much one should read into those turnover rates. What's a good benchmark?

For example, this article claims it partly has to do with monthly rebalancing of the index (versus annual rebalancing of stock funds). They also claim it has to do with bonds that are called early and the like. 

They even provide a benchmark of 42% (with relevant calculations) which would apply to a passive fund. This is roughly consistent with Vanguard's funds which have low expenses. IEF is only 65%.

 I don't know what an appropriate benchmark for active funds would be.

Which bond funds are you looking at?

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