The financial news has been filled recently with pundits and commentators saying we’re in a government bond bubble or even an “everything bubble.” We too have wondered about that possibility, but we disagree. Interest rates are low, yes. But are we in a bubble? No.
As the financial world has evolved, bonds have taken on different roles in investors’ portfolios. These days, high grade bonds primarily bring income and downside protection to a portfolio. However, with interest rates at current levels, small declines in interest rates can lead to outsized increases in bond prices, an effect known as convexity. This effect is amplified for bonds which don’t mature for many years (Display 1).
A striking case study played out in 2019. Two years earlier, the government of Austria issued a 100-year bond that paid 2.1% interest. That may sound like a pitifully low return to earn over 100 years. However, as rates in Europe fell in 2019, that bond’s price nearly doubled from around 110 euros to a peak of over 200 euros, creating a windfall for investors (Display 2).
As a result of this effect and with government bond yields low around the world, there’s an increasing risk of people buying bonds to speculate, which could inflate a bubble. Again, we disagree, but we can’t rule out the possibility that a bubble inflates from here.
To begin with, it helps to think about what makes a bubble.
One common attribute of bubbles is that they take a good idea which has been true for a long time and push it beyond its breaking point. The housing bubble was a classic example, with widespread claims that housing was a great investment because it always went up. Similarly, the idea that Treasury bonds are the safe investment is well established. We wouldn’t say that it’s been taken too far yet. But it could be. Let’s consider this….
We define a bubble when an asset’s price becomes wildly detached from its economic fundamentals and is instead based on the hope of selling to another speculator at a higher price. This pattern shows up time and again in economic history. From the tulip mania of the 1600s to the South Sea bubble of the 1700s and the dot-com bubble at the turn of the 21st century, the same animal spirits were unleashed.
So is that what we’re seeing in the government bond market today?
As interest rates fall close to zero and in some cases below zero, there are two main reasons for an investor to buy bonds with the expectation of a positive real (net of inflation) return.
Reason #1 is if the investor holds the bond to maturity and inflation comes in sufficiently low or there’s outright deflation. Then the return on the bond can be enough to earn a positive return after inflation.
Reason #2 is if the investor buys the bond in anticipation of rates falling, is right, and sells before maturity. In this case they make their money from capital gains, since bond prices rise as rates fall.
We don’t currently see any mania-like dynamic in the government bond market, but we could if more people start buying bonds for Reason #2, armed only with the hope of selling to someone else for a higher price in the future. That hope could be exacerbated if more people become convinced that rates will fall from here, if more people learn that bond price moves get larger as interest rates fall, or if governments issue more long-dated debt which moves more sharply as rates change.
Has the world seen a bond bubble before? A bond bubble is a strange concept. Bubbles are usually sparked by “irrational exuberance” and the fear of missing out. Meanwhile, bonds are usually thought of as boring and go up in times of panic, not exuberance.
In fact, a bond bubble has happened in the US in the past, although it’s been a long time since we’ve seen anything like that. But in the 1940s, it was common to speculate on US Treasuries in search of capital gains. Bond prices regularly rose before falling back toward par at maturity, providing a tailwind for investors to take advantage of. Even more importantly and aggressively, though, bond buyers thought that rates as high as 2.5% might never be seen again, prompting a “bidding frenzy” for Treasury bonds after World War II.
Where we do see select signs of froth is in the market for non-government credit. Part of this is due to a segmentation of investors in each market—those more focused on risk mitigation skew toward the government bond market while those more focused on return seeking skew toward the general credit market. And in that general credit market, some investors have been increasingly speculative in chasing yield.
However, in the government bond market, we don’t see those warning signs. That said, the government bond market is not monolithic. For example, we see more reward per unit of risk in intermediate-term bonds, rather than long-dated ones which would suffer larger losses if rates rise. And we continue to see central banks buying bonds to keep rates low. Their buying has driven pricing more than that of any other set of market participants. But perhaps that’s because the economy simply hasn’t been able to bear higher rates. Given the secular trends we have written about recently, seeing bonds at historically low yields is not entirely surprising.
The risk we run with such low rates is potentially provoking the market’s animal spirits. We recognize that low rates mean there is a chance these could be inflamed, either in the government bond market or elsewhere. As always, we’ll continue to invest as prudently as possible and look to take advantage of situations when the market skews too heavily toward pessimism or optimism. Over the course of time, we expect that approach to reap rewards for our investors.
1 There are technically two other potential reasons for an investor to buy a bond with a negative yield, although one depends on currencies and the other involves an expected loss. In the first case, depending on expected inflation in different countries, by buying a foreign bond with a negative interest rate and hedging the foreign currency into domestic currency, you can end up with a positive return. AllianceBernstein’s fixed income portfolio managers have in fact done this recently, by buying negative-yielding European debt and converting it into dollars, earning a positive yield for US-based investors. The other case involves buying bonds while expecting to lose money on them. If the investor believes bonds will protect their portfolio in the case of downward economic shocks, they may be willing to lose money and treat that as an insurance premium to protect against a larger loss.
2 As documented in A History of Interest Rates, by Sidney Homer and Richard Sylla.
- Christopher Brigham
- Senior Research Associate—Investment Strategy Group