Premature fears of a bond bubble

There has been much talk of a bond bubble during the past few years.

In fact, in August 2010, an article by Jeremy Siegel, the noted finance professor at the University of Pennsylvania's Wharton School, was titled “The Great American Bond Bubble.” Paradoxically, the yield on the 10-year U.S. Treasury note — which was 2.8% at the time of the article — ended the first half of 2012 at 1.6%, a decline of 120 basis points in the ensuing two years.

The term “bubble” is used very loosely.

Researchers at the venerable Swiss Federal Institute of Technology concluded in May 2010 that “neither the academic nor professional literature provides a clear consensus for an operational definition of financial bubbles.” Bubbles are typically seen in hindsight and are associated with severe price declines. For example, the bursting of the tech bubble in the early 2000s saw the Nasdaq stock index lose almost 80% of its value during the next 2½ years. Following the collapse of the hugely frothy Japanese real estate market in the late 1980s-early 1990s, the Japanese stock market, which peaked at the end of 1989, declined by more than 60% in just more than 2½ years. More spectacular “bubble burstings” include the collapse in the price of silver in the early 1980s when, after having run up to almost $50 an ounce from less than $5 a few years earlier, the price of the metal plummeted by 90% in 2½ years.

The reason for all the talk about a bond bubble is record low interest rates. The yield on the 10-year U.S. Treasury has been lower over the past three years than it has ever been in the past half century. After peaking at almost 16% in 1981, the 10-year now yields just 1.5%. Investors fear that an interest rate spike could cause substantial losses. Some of the catalysts for a sharp rise in yields include a) U.S. sovereign credit downgrade b) inflation and c) renewed risk-taking. Figure 1 shows what happened to U.S. Treasury yields last year when the major credit ratings agencies turned negative on their outlook for the U.S., followed by Standard & Poor's downgrade. Contrary to expectations earlier in 2011 (including comments by S&P) that a negative action by the ratings agencies would cause Treasury yields to rise, the 10-year Treasury yield — which was above 3% before the agencies' actions — ended the year below 2%, a decline of more than 100 basis points. A similar picture can be seen in the Japanese bond market (Figure 2) where, despite repeated cuts beginning in 2000 — from the AAA level in the sovereign credit rating to single A+ just two months ago — the yields on Japanese government securities are near record lows.

Meanwhile, the much-heralded inflation bogeyman is yet to appear as core inflation remains benign. One of the main precipitators of the Great Recession was the housing bubble in the U.S. and its subsequent collapse. After peaking at an annual selling rate of around 1.4 million units in mid-2005, sales of new homes plummeted by 80% in the next 5½ years. This put the sales rate at its lowest level in more than 50 years even though the number of U.S. households has more than doubled during that time period. Despite the prolonged recession and continued weakness in the housing market, the shadow housing inventory (foreclosures plus 60+ day delinquencies) of more than 4 million homes is still more than four times the level seen before the financial crisis. Consequently, a vigorous and lasting economic recovery (a necessary ingredient for renewed risk-taking) is likely to take much longer compared to past economic cycles.

While the catalysts for a spike in interest rates have a fairly low probability of occurrence, what would the impact be for pension plan sponsors if such an event did take place?

Typically, fixed-income allocations for institutional pension plans have a major component in a broad fixed-income segment such as the Barclays Capital Aggregate index. Table 1 shows some of the important metrics such as duration, yield and option-adjusted spread for this index and for its major sectors. With a duration of around five years, the effect of a rise in yields by one percentage point would be to cause a 5% decline in the value of the index. However, there are other factors — such as the yield of the index and sector spread tightenings — that would offset this negative effect. Table 1 summarizes the effects that a doubling of interest rates (rising by two percentage points), over a one-year period would have on the Aggregate index. When Treasury yields rise, non-Treasury spread sectors usually experience a narrowing in spread differentials as investors become less risk-averse. With spread sectors relatively cheap (in the 70th to 85th percentiles of cheapness), a rise of 200 basis points in Treasury yields is likely to be accompanied by the spread tightenings shown in Table 1. Active managers typically overweight spread sectors (and underweight Treasuries) in a rising yield environment. As spreads to Treasuries compress, spread sectors outperform Treasuries. Therefore, while a rise of two percentage points in Treasury yields will cause a price decline of just more than 9%, the yield on the index together with the positive contributions from spread compression and spread sector overweights will cushion the negative effect, and reduce the overall decline to 3.5% at the end of one year. By extension, even a tripling or quadrupling in interest rates will result in total declines that are a far cry from the 65% — and worse — declines following the bursting of financial bubbles.

Can yields stay low? Besides the lack of an impetus, as described earlier, for the catalysts to a sharp rise in yields, there are significant headwinds emanating from the on-going European sovereign debt crisis, the synchronized global economic slowdown, the negative consequences from an impending U.S. fiscal cliff, and the potential flare-up in the Middle East related to Iran's nuclear weapons ambitions. Finally, Japan is a case in point: 10-year Japanese government bonds have remained below 2% for more than 12 years.