Although many analysts do not think “the bond market” as a whole is in a “bubble,” most analysts do think that bonds are becoming more risky, especially treasuries and high yield corporate bonds or junk bonds, according to a number of recent articles in the financial press. These articles include “Bond Markets Get Riskier,” by Carrick Mollenkamp and Mark Gongloff (WSJ); “As Bond Market Rallies On, Risks Lurk Beneath Surface,” by Mark Gongloff (WSJ); “The Bond ‘Bubble’: Are Small Investors Taking Too Big a Bet,” by Jason Zweig (WSJ); and “Bond Market at ‘Extreme Danger Level’: Strategist,” by Antonia Oprita (CNBC.com).
Many high yield bonds are being issued without the usual covenants that are designed to protect investors. Normally, seasoned high yield bond investors require issuers to covenant not to take on too much other debt, not to pay out their cash in salaries and dividends, and to allow bond holders to sell back their bonds at 101% of par value in the event of a change of control (i.e. corporate takeover). Now, with demand for junk bonds surging, issuers see no need to make those promises. Buyers are snapping them up anyway.
In the third quarter, individual investors put $87.7 billion in bond funds and pulled $42.6 billion out of stock funds. This despite the relative underperformance by bonds compared to stocks. The Dow Jones gained 10.4 in Q3 compared to 6.5% for high yield bonds, 4.9% for investment grade bonds, and 2.7% for Treasuries. For the year, the Dow is up less than 3.5% while high yield bonds have returned 11.5%.
High yield issuers have issued nearly $190 billion in Q3, which has already topped the annual record with one more quarter to go.
The spread between junk bond yields and Treasuries has contracted by over 0.8% to 6.29%. But spreads were 2% in 2007 and are typically 5%. This leads some to conclude that high yield bonds are good buys.
One particular “bubble” area appears to be in the U.S. Treasury bond market. U. S. Treasury bond yields have been driven down by massive buying by the Federal Reserve and to a lesser extent foreign investors, but not U.S. investors, according to Zweig’s article.
If interest rates rise by 1%, long-term Treasury bond prices will fall by 10%, but the same 1% interest rate move would only cause a typical short-term bond fund to fall by 3%, says Zweig. But retail investors are apparently not investing heavily in long-term bonds. And the flow of mutual fund money into bond funds has not been that dramatic ? as of August 2010, 24% of all mutual fund assets were in bond funds ? up from 20% as of the end of last year, according to Zweig.
Federal Deposit Insurance Corporation Chairwoman Sheila Blair, however, was cited by CNBC.com as saying that a bubble is in the making in “bond markets.”
“The headlines blare ‘bond bubble’ but everyone is looking at Treasury rates,” says R. Matthew Freund, senior vice president and head of USAA’s portfolio management team. “So I think we first need to determine what bonds they are talking about and then define what they mean by bubble.
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