In the last week, I’ve received a few emails from readers who were concerned about a recent MSN Money article. The following snippet sums up the main message of the article:
“In just the past four years, investments into bond mutual funds have doubled to $4 trillion. But this perceived bastion of safety is more like a ticking time bomb waiting to explode. And when it does, it will devastate any portfolio with a heavy allocation to Treasury bonds.”
Scary language. But based on the portfolios I see most often, I don’t think most investors need to be scared about anything that could be referred to as a bond explosion.
Bond Bubble Fears
It’s true that interest rates are currently very low, and it’s true that bond prices go down when interest rates go up. But there’s no telling when interest rates are likely to rise. They could fall first (though not very far) or stay right where they are for an extended period of time.
In addition, with short-term or intermediate-term bonds, the losses would be very unlikely to approach anything like the losses that can occur in the stock market.
For example, Vanguard’s Intermediate-Term Treasury Fund has an average duration of 5.2 years. Even if rates rose by 3% overnight, that’s only a ~16% decline in price — not even close to what can happen to stocks in just a run-of-the-mill bear market. And most of the the time, rates don’t increase overnight. Instead, they increase over a period of time, during which an investor in a bond fund will be earning interest that will help to offset any declines.
By way of analogy, if the popping of a stock bubble is like the popping of a birthday party balloon, the popping of a bond bubble is like the popping of a bubble on a sheet of bubble wrap.
That said, there’s no reason for bond investors to be particularly optimistic.
Realistic (Low) Expectations
In a webcast last week, Ken Volpert (the head of Vanguard’s Taxable Bond Group) suggested not to expect returns of more than 1.7% or so from Vanguard’s Total Bond Market Index fund for the near term future. Based on reader correspondence, I know this surprised some people given how much lower this figure is than historical averages.
But this projection should be no surprise because, at any given time, the current yield on a bond fund is the best estimate we have for what return the fund will earn over the fund’s duration. And the yield on Vanguard’s Total Bond fund is currently sitting at just 1.64%.
In other words, for the near future, we should probably expect bond returns to be significantly below historical averages. And we should definitely expect bond returns to be below recent past returns (a large portion of those recent returns having been due to price increases as rates dropped).
In short, a period of very low (or possibly even negative) inflation-adjusted returns for most bonds is very likely — almost a mathematical certainty. But, unless your bond portfolio has an unusually long average duration, a calamitous drop is still far more likely to come from the stock side of your portfolio than from the bond side of your portfolio.