The Great Bond Bubble?

Pimco's Bill Gross, no stranger to the bond market, has opined that there is a bubble indeed.  And, for good reason.  Treasury yields are at generational lows.  And, the bull market in bonds has lasted for about a decade.  So, how much lower could bond yields possibly go?

Bonds carry two types of risk.  One is the risk of default.  Two, is what is known as "duration" risk, or the impact on principal from changes in prevailing interest rates.  Duration is the more significant since, given the very low rate structure, any rise in rates will result in capital losses which will not be offset by the yield.

The longer the maturity, the greater the duration.  For example, if one holds a 30 year maturity, even a 1% rise in rates will produce a double-digit loss.

The default risk is not insignificant, but it is fairly low since the Federal Reserve (FED) can simply print money, if necessary to ensure that maturities are honored.

So, the ingredients of a bubble are certainly present and, in fact, Gross may be correct.  However, "Marko's Take" believes that for the intermediate term, bond yields will head lower still. 

Bond yields are driven by several factors.  Inflation, supply and demand and probability of default are the most critical.  Currently, given the now approaching "Second Dip", inflation is not likely to accelerate.  In fact, we are more than likely in the early phases of a new DE-flation scare. 

If we look to the last two decades in Japan, we can speculate as how low interest rates can go.  The "Land Of The Rising Sun" now has become "The Land Of The Falling Yields".  Tokyo has been mired in a depression since its own stock market and real estate bubbles popped simultaneously in 1990. 

Naturally, at some point, as the national debt is monetized through liberal use of the printing press, we can expect a re-emergence of inflationary pressures.  That will happen in the not-so-terribly distant future.  When it does, Gross will be correct, but it may not occur for months or years.

Bond investors have nothing but poor choices.  If one invests in short-term bonds to avoid the duration risk, the yields are extremely low, especially on an after-tax basis.  The 2 year note is at a fat 0.48%.  If one reaches for yield by purchasing longer maturities, one faces substantial principal risk.  Thus, allocating a good portion of one's portfolio to fixed income is not particularly attractive.

A better choice for fixed return would be higher grade utility stocks.  They have generally paid good dividend yields which grow over time.  Their risk is low since utilities are regulated monopolies whose product is necessary, unless, of course, you wish to have no light, no heat, no gas and no electricity.  A second group of high dividend paying companies are oil stocks.  Wanna try living without transportation?

In the current environment, attractive investment opportunities are few and far between.  We continue to recommend holding a portion of assets in GOLD while staying liquid in anticipation of a MUCH better buying opportunity.

Marko's Take