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The Bond Bubble Myth: Will Rising Rates Sink the Bond Market?

by Ather Bajwa, CFA,® CPA, Senior Fixed Income Analyst

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"By any measure, real long-term interest rates are much too low and therefore unsustainable. When they move higher they are likely to move reasonably fast. We are experiencing a bubble, not in stock prices but in bond prices."- Alan Greenspan (July 31, 2017)1


This time it's different

Concerns that the Federal Reserve's policies of keeping interest rates near record lows could lead to galloping inflation, higher interest rates, and the "bond bubble" (i.e., bonds are considerably overvalued) bursting are not new. In fact, Mr. Greenspan first wrote of a bond bubble in June of 2010,2 warning that "long-term rate increases can emerge with unexpected suddenness." A few months later nearly two-dozen prominent economists and investors penned an open letter to the Federal Reserve3 citing concerns that record low interest rates (a near zero Fed Funds rate at the time) and quantitative easing (large-scale U.S. Government bonds purchase plan) risked "currency debasement and inflation" and could "distort financial markets."

Bonds tend to be a critical component of most investor portfolios as they have a fixed maturity and are generally structured to make periodic fixed payments, which are determined by the level of interest rates. A key determining factor of interest rates is future expected inflation (ability of the borrower to make payments, and credit risk, being another). While we agree with the notion that interest rates (and inflation) are headed higher and that investors should be actively monitoring their bond portfolio, we disagree with the assessment that ensuing higher rates will lead to oversized bond price declines. Consider the fact that although the Federal Reserve has raised the Fed Funds rate four times since December of 2015, long-term U.S. interest rates have remained near record lows (Figure 1). In our opinion, low interest rates persist (even while the unemployment rate is at multi-year low and the U.S. economy continues to expand at a reasonable pace), due to both structural and economic issues.


Oh inflation, where art thou?

A key reason why interest rates remain anchored is the absence of meaningful inflation. While many market participants have continually called for rising prices, inflation has consistently remained muted (Figure 2). We believe there are deep-rooted reasons for persistent low inflation, which are unlikely to dissipate in the near-term. This year, for example, we have seen a string of inflation data that continues to show many areas of weakness, including autos (where sales of both new and used autos remain soft), retail (insistently falling prices), hotel prices, and wages.

Another key structural reason for low inflation is the changing U.S. demographics landscape. By one estimate, as many as 10,000 baby boomers are turning 65 every day — a trend expected to continue well into the 2030s.4 This pending retirement boom, along with the aging U.S. population, will likely lead to slower than historic U.S. growth rate and below average inflation. According to a paper published by the Federal Reserve, due to these demographic trends, their model suggests "low investment, low interest rates, and low output growth are here to stay, suggesting that the U.S. economy has entered a new normal."5 A phenomenon we see repeated globally, particularly among developed nations.


Nothing to fear but fear itself

The U.S. economy has entered the ninth year of expansion, and we expect another year of solid (around 2%) but unspectacular growth. In our estimation, the Federal Reserve will continue to become less accommodative by raising interest rates at a modest pace and shrinking its balance sheet in a prudent manner (from approximately $4.5 trillion currently to around $2.5 trillion in two to three years). Although the subsequent Fed actions will likely lead to higher yields, we expect the pace to be both gradual and somewhat limited in scope.


While the path of interest rates may turn out to be somewhat volatile, in our estimation, the current benign economic environment, modestly rising interest rates and strong demand for consistent income (particularly from retirees) bodes well for the bond market. Similarly, rising rates can actually be beneficial for bond investors, as higher interest rates mean investors can reinvest their proceeds into higher yielding securities (Figure 3). This strategy of reinvesting can be particularly beneficial if investors focus on short maturity and floating rate bonds.

For instance, from 2003 to 2006 the Federal Reserve raised the Fed Funds rate from 1.00% to 5.25% (a considerably quicker pace than currently forecasted) and during those four years, the bond market delivered an average annual return of 3.80%.6 Importantly, however, we believe an active approach to bond investing is the most appropriate course of action to take advantage of opportunities created as a result of potential market volatility.

Related Disclosure Information

1 https://www.bloomberg.com/news/articles/2017-07-31/no-bubble-in-stocks-but-look-out-when-bonds-pop-greenspan-says

2 https://www.wsj.com/articles/SB10001424052748704198004575310962247772540

3 https://economics21.org/files/pdfs/e21_An_Open%20Letter_to_Chairman_Bernanke_QE2.pdf

4 http://states.aarp.org/are-you-ready-for-retirement-is-retirement-ready-for-you/

5 https://www.federalreserve.gov/econresdata/feds/2016/files/2016080pap.pdf

6 Bond Market represented by the Bloomberg Barclays Aggregate Bond Index, Calculations using Morningstar

Any opinions, projections or recommendations contained herein are subject to change without notice and are not intended as individual investment advice.

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