Are Bonds the Next Big Bubble?
With interest rates at historic lows, a lot has been written about a looming “bond” bubble, including this article in The Wall Street Journal (subscription required).
Before we take a closer look at how a bond bubble might or might not affect you, it is important to understand the basic workings of bonds, specifically how interest rates affect bond prices, and how these factors impact a potential “bond bubble.”
After working the first 12 years of my professional career in the bond arena at a major brokerage firm in Seattle, I developed a fairly good understanding of bonds. Today, interacting with all types of investors, I am reminded that a lot of folks could benefit from a quick primer on bonds, and the issues that need to be addressed when constructing a bond portfolio to address both the current deflationary climate and the potential for inflation and rising rates down the road.
To start, think of a bond the same as a CD. I know there are a lot of differences between bonds and CDs, but at the core, they are similar – an investment that pays a fixed income on a regular basis, and has a stated maturity.
For this discussion, the issue at hand is the price you would receive on your bond if you decide to sell before it matures. Interest rates impact the price of bonds in an inverse manner. When interest rates go up, the price of the bond declines. When interest rates decline, the price of the bond increases.
Let’s look at an example. Say you invest $10,000 in a corporate bond issued by IBM that yields 5 percent interest and matures in 2020 – a ten year bond. If you hold the bond to maturity, you will receive the entire $10,000 principal back, provided of course, the bond doesn’t default in the meantime. If interest rates decline, and you want to sell your bond prior to 2020, chances are the selling price you will receive will be greater than $10,000.
The opposite is true if interest rates increase over the next ten years, and you want to sell your bond early. In this scenario, the price you receive would be less than $10,000.
This is where a bond bubble enters into the discussion. Market pundits are saying that, because interest rates are so low, and the chance of inflation (and higher rates) so high, a sharp increase in interest rates will cause a steep decline in bond prices, and a bursting of the bubble.
Even if rates do increase dramatically, and the price of your bond declines, this only impacts you if you sell your bond before it matures. If you hold your bond to maturity, you will get your entire principal back, no matter HOW far your bond declined in the interim.
Getting a good grasp on bonds is important, especially for folks who are nearing retirement or are retired, as bonds are likely to make up a large portion of your portfolio. So stay tuned – when it comes to bonds, we have a lot more to review.
Before we take a closer look at how a bond bubble might or might not affect you, it is important to understand the basic workings of bonds, specifically how interest rates affect bond prices, and how these factors impact a potential “bond bubble.”
After working the first 12 years of my professional career in the bond arena at a major brokerage firm in Seattle, I developed a fairly good understanding of bonds. Today, interacting with all types of investors, I am reminded that a lot of folks could benefit from a quick primer on bonds, and the issues that need to be addressed when constructing a bond portfolio to address both the current deflationary climate and the potential for inflation and rising rates down the road.
To start, think of a bond the same as a CD. I know there are a lot of differences between bonds and CDs, but at the core, they are similar – an investment that pays a fixed income on a regular basis, and has a stated maturity.
For this discussion, the issue at hand is the price you would receive on your bond if you decide to sell before it matures. Interest rates impact the price of bonds in an inverse manner. When interest rates go up, the price of the bond declines. When interest rates decline, the price of the bond increases.
Let’s look at an example. Say you invest $10,000 in a corporate bond issued by IBM that yields 5 percent interest and matures in 2020 – a ten year bond. If you hold the bond to maturity, you will receive the entire $10,000 principal back, provided of course, the bond doesn’t default in the meantime. If interest rates decline, and you want to sell your bond prior to 2020, chances are the selling price you will receive will be greater than $10,000.
The opposite is true if interest rates increase over the next ten years, and you want to sell your bond early. In this scenario, the price you receive would be less than $10,000.
This is where a bond bubble enters into the discussion. Market pundits are saying that, because interest rates are so low, and the chance of inflation (and higher rates) so high, a sharp increase in interest rates will cause a steep decline in bond prices, and a bursting of the bubble.
Even if rates do increase dramatically, and the price of your bond declines, this only impacts you if you sell your bond before it matures. If you hold your bond to maturity, you will get your entire principal back, no matter HOW far your bond declined in the interim.
Getting a good grasp on bonds is important, especially for folks who are nearing retirement or are retired, as bonds are likely to make up a large portion of your portfolio. So stay tuned – when it comes to bonds, we have a lot more to review.
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