Over the past few years, the financial markets have been fairly kind to investors. Stock indexes have surged and continue trading near all-time highs. Declines have been mild and short-lived. Even prices for gold and bonds, long used by investors to seek safety and comfort against economic and stock market uncertainty, have dramatically risen.
However, there is concern the extreme high prices in the U.S. bond markets are reaching an unsustainable level. The end result, many experts conclude, will be the sudden burst of a “bond bubble.” Bonds, like loans, are obligations where the lender, typically a corporation or government body such as the U.S. Treasury, borrows investor funds with a promise to repay with interest. As with any asset, a bubble occurs when prices become highly overpriced relative to its true value, then rapidly decline to a more realistic price. The potential risk of loss to investors can be significant. So, what exactly is causing concern of potential turmoil in the bond markets?
Cautionaries point to the bond yield curve. The yield curve is a measure that tracks the difference in yield, between short-term and long-term interest rates. Similar to your local bank CD, longer-term bonds yield higher rates of return, rewarding the investor for committing their funds for an extended period. In December 2013, the difference between yields on the 2-year and 10-year U.S. Treasury note was 2.66 percent. However, the spread has been steadily declining and recently fell to just 0.65 percent, its lowest in 10 years.
This “flattening” of the yield curve is caused by rising short-term rates and declining long-term rates. Short-term rates have been driven higher by the U.S. Federal Reserve. Since December 2015, there have been four rate hikes to the benchmark fed funds rate, upon which short-term debt is often based. The Fed has proposed seven more rate hikes over the next two years.
Long-term bond yields have been driven to historic lows by increased demand for long-term debt. As demand pushes up prices, a bond’s yield declines, reflecting the inverse relationship between a bond’s price and its yield. Despite the recent strength in American and global economic growth, concerns remain on its sustainability. Consequently, investors have been buying long-term U.S. bonds as a hedge against economic downturn.
Foreign investors have also been buying U.S. long-term debt due to the ultra-low, and even negative returns, on similar debt in their home countries. For example, the current yield on the U.S. 10-year Treasury note is around 2.4 percent. Compare this to the 0.037 percent yield on the Japanese 10-year bond or the -0.349 percent yield on the German 5-year bond. That’s right, you are actually paying the German government to loan them your money.
The red flag in the yield curve is with the longer-term bonds and their ultra-high prices and related ultra-low yields. If bond investors become convinced that economic growth is sustainable, which would trigger continuing Fed interest rate hikes, there could be a mass exodus from bonds as investors quickly sell off their highly overpriced yet low yielding bonds in search of cheaper and higher yielding investments.
The inherent nuances of the bond market itself could accelerate any collapse in bond prices. For example, a typical share of John Deere stock is virtually identical to the other 321 million-plus shares issued by the company. You can trade that share of stock on an easily accessible financial exchange with a ready supply of buyers and sellers. Bonds, however, are very idiosyncratic, with varying maturities, coupon rates and other covenants. They are typically traded in highly decentralized markets where the specifics of each bond must be matched with a buyer and seller. With a limited number of buyers and sellers, bond markets tend to be less liquid. A sudden and massive sell-off in bonds could potentially send prices plummeting.
A large correction in the bond markets, for now, is conjecture by those who see unwarranted high prices in bonds. One can argue that similar cautionaries have railed against the excessive valuations in the current stock market, which continues to breach all-time highs. In reality, it is difficult to judge the true conditions behind specific markets or the investor behavior which influences their movement. For now, let’s simply consider it food for thought.