Bond Bubble Bursting?

Stelzer Observes the Market

Irwin Stelzer tells us what market watchers have suspected for a few weeks now: bonds are done. After one last strong rally that seems to have ended in mid-June, the bottom appears to be dropping out of the market.

The three-year bear market in stocks resulted in a boon for bond-holders, especially government bond-holders, as fear drove cash into these securities, raising the prices (though lowering the yields). Bond-holders have not necessarily benefited from terrific income streams or cash flow (the main reason most ordinary investors, especially elderly ones, buy bonds), but they've seen their accounts appreciate in ways previously known only to more aggressive stock-holding investors. This unusual phenomenon seems to be over now.

A Brief Explanation of Bonds

Bonds are debt instruments by which issuers borrow money from investors; they are designed to give streams of income or interest to investors (who are acting as lenders) along with the principle or "face value" returned at the time of maturity. However, unknown to all too many investors, bonds also fluctuate in value on a daily basis as do stocks. Since government bonds have little or no credit risk, their main cause of fluctuation is interest-rate movements. For example, if you invest $10,000 in a 10-year Treasury Note with a yield or "coupon" of 4% ($400/year of income), but rates go up to 5% or 6% for the same security in a few years, your 4% bond will be worth less at that time than the $10,000 you originally paid for it. In fact, if rates go up to 6%, you only need $6667 to generate the $400 cash flow, so $6667 is what your original $10,000 investment would be worth in that case. (Of course, the bond will also be worth more if interest rates decrease which is precisely what has happend to existing bonds over the last few years.) You are only guaranteed to get your original $10,000 at the time of maturity when the government will redeem your bond. In fact, government bonds tend to have lower "coupons" or yields precisely because of their safety and are, therefore, generally a bit more interest-rate sensitive than higher-yielding corporates. (A security that yields or gives you more of a fixed, steady payout than another security will generally be less sensitive to interest-rate movements than that second security.)

Complicating this even further, there are different interest rates (long rates and short rates, for example) which affect different bonds differently. But, as a general rule, bond prices or values move inversely to interest-rate movements.

So as rates tick down (in an effort to stimulate the economy), bond prices soar. Moreover, as fear of corporate bonds in the midst of economic scandal spurred more buying of government-backed securites (the so-called "flight to quality" or "flight to safety") recently, prices went up and yields came down even more, resulting in skyrocketing prices and the lowest yields on Treasuries in forty-five years.

The end of rate-cutting seems to have finally arrived, so prices have tumbled in the last few weeks. The good news in all of this is that the bond market is anticipating an economic recovery. Alan Greenspan has not indicated that he plans to raise rates anytime soon, despite his decision to cut rates only .25% instead of .50% recently. Nevertheless, the market is girding for growth, complete with inflation -- to the short-term detriment of bond-holders who have seen their principle erode.

Unfortunately, it is very difficult to time these movements; for all we know the damage has already been done to bonds for the time being. But who knows? As per our usual disclaimer, we are not financial advice-givers; but we've noticed that most individual investors do more harm to themselves trying to time these capricious movements rather than sticking to a long-term allocation. Our main objective is to try to understand what the financial markets are "saying" about the economy; and the bond market has been voting for improvement.

Kudlow's Moment

This leads us to a tougher piece by Larry Kudlow who loves what the bond market is saying and who advises Alan Greenspan to go the way of Sandy Weil, the recently retired CEO of Citigroup. Kudlow wonders how Greenspan went so quickly from fears of deflation to hopes of strong economic recovery later this year. This shift in Greenspan's sentiment caused a huge bond sell-off in anticipation of stabilizing and perhaps even higher interest rates so that the yield on the 10-year note went from nearly 3% to 4%. Unlike Stelzer who argues that traders have a different opinion than Greenspan, Kudlow blames the apparently ambivalent Greenspan for causing the manic bond market. Larry Kudlow is possibly the US economy's and the stock market's biggest cheerleader; he is as perennially bullish on stocks (though not necessarily bonds) as anyone can be. The last three years have not been Larry Kudlow's kind of market. I wouldn't want to say anything so harsh about him as "even a broken clock is right twice a day" because his bullishness comes from his patriotism and because as long as one keeps a very long time perspective, he is, in fact, much more right than wrong. After all, as Kudlow would eagerly and correctly point out, nobody has ever made money betting against the American economy over the long-term. Now may be the time in the market cycle for Kudlow to shine.