Maybe it is just me, but I seem to see a lot of news stories about the so-called "Bond Bubble". In an effort to educate readers I'll breakdown what this is referring to along with a brief discussion of interest rate risk (also known as duration), then let you make up your on mind as to the potential risks:
First of all, the Bond Bubble has nothing to do with the actor Daniel Craig or the movie franchise. We are talking fixed income investments that you probably hold in your investment accounts. Those fixed income investments may be in the form of individual bonds or more likely in Bond Mutual Funds.
Most investors have a portfolio that has some type of allocation model (60/40 or 80/20, etc). The 60 would mean 60% Stock funds and 40 would mean 40% bond funds. Simple enough, right? This is traditional Asset Allocation modelling, whether you have designed yourself or with the help of a financial advisor.
Since the top of the tech bubble in early 2000, bonds have steadily increased in price (principal value) as interest rates have fallen. The 10 year treasury note was paying 6.5% annual interest in 2000. Now it is paying just under 2%. To give you a visual, think of a see-saw when you were a kid. As one end goes down the other comes up. That is exactly what has happened with Bonds, as interest rates have dropped over the past 13 years the price of the bonds have risen. So your total return over the past decade has been fairly nice on what we assume to be the conservative part of your investment portfolio.
Could danger be lurking?
It's been a heck of a run in bonds, but we are at a point where you could actually achieve a negative short/intermediate term return if rates rise. How is this possible? We are all familiar with the Federal Reserve's Quantitative Easing program, where they have gone into the market and purchased treasuries in order to keep rates artificially low to stimulate the housing recovery. The issue as we saw last week when the Fed Reserve meeting notes were released is that they are now debating how to exit this program. If they do, then interest rates will more than likely begin to rise. As rates rise bond prices will drop.
If you are a long term holder then you will probably be okay, your bonds may give back some principal value but over time the higher rates will compensate you with dividends. If on the other hand you are closer to retirement and don't want to see your account value drop then you need to figure out how much interest rate risk your fixed income allocation has. This value is called Duration and can be thought of as the % your bonds would drop with a 1% rise in interest rates.
Estimated Duration of key fixed income components (courtesy of S&P, Bloomberg and Barclays):
5 year treasuries duration = 4.88
10 year teasury duration = 9.02
Barclays US Aggregate Bond duration = 5.20
ML High Yield index duration = 4.23
Is there a solution?
Unfortunately we are at a junction where everything has risk, but reviewing your "conservative" bond allocation might be a good idea. One strategy would be to diversify your fixed income holding geographically and take a look at foreign and/or emerging market bonds. Another would be to look at alternatives to traditional bonds, such as floating rate loan funds or funds backed my mortgage debt. And a final option would be to find the lowest duration (shortest term) fixed income fund you can, if you think rates will move significantly this year. *Please remember that all of these have risks and may not be right for everyone.
Simply make sure you are not lulled into a false sense of security if you are a conservative investor. Bonds have been a great hold and we all still use them in portfolios. Just go in with your eyes open as to the risks lurking. Maybe the Fed is successful in keeping rates low indefinitely, or maybe they begin to rise this year. No one knows, but at least you will have a plan of attack whatever happens.