The Bond Party is Over

Last Updated Dec 1, 2010 1:53 PM EST

Is a bond bubble on the horizon? Can't say for sure, though I can say with certainty that the recent high returns are over. Here's why I'm sticking my neck out to make a rare prediction and what it means to you.

The facts
High quality bonds weathered the financial crisis and acted just as they were designed to act - to be a shock absorber to our equity portfolio. Take the Vanguard Intermediate Treasury Bond Fund (VFITX) as an example, which clocked in a 6.76 percent annual return over the past three years. Not too shabby.

To see why this can't be replicated, however, we must first start by looking at the past to see the sources of that great return.

Source of the three-year return
This Treasury bond fund has an average maturity of about 5.8 years. The closest maturity I could find data for was a five year Treasury bond. Three years ago, a five year Treasury was yielding 4.16 percent. This bond fund delivered this 4.16 percent yield, plus an additional 2.60 percent, producing a 6.76 percent three year annual return.

The extra return came from declining interest rates. Today a five year Treasury bond yields only 1.53 percent annually, a decline of 2.63 percentage points from the 4.16 yield of three years ago. In admittedly rough numbers, each one percent decline in the rate translated to an annualized one percent increase in the annualized yield over the past three years.

Thus, a rough approximation of the sources of the bond fund's returns are as follows:
  • Treasury yield 4.16%
  • Interest rate decline 2.60%
  • Total return 6.76%
Back to the future
As previously mentioned, today the five year Treasury is yielding only 1.53 percent annually. In order to generate the same 6.76 percent annualized return over the next three years, the yield from interest rate declines must contribute 5.13 percent annually to total 6.76 percent. For this intermediate term bond, rates would have to decline by about another five percent over the next three years.

While I rarely predict the future, I'm going to make an exception here - it absolutely can't happen! A decline of five percentage points would translate to a yield of about minus 3.5 percent annually. That would be the equivalent of lending $100 for the promise of being paid back $96.50 in a year. Investors would certainly prefer to lock up the hundred bucks in the safe deposit box to get the full hundred bucks back.

What this means
Sticking with this example of an intermediate term Treasury, the implications are enormous. The lowest rate nominal yields could possibly approach is zero. That unlikely decline of about 1.53 percentage points translates to a possible upside of about a three percent yield over the next three years, approximately half the current yield and half the largest decline in interest rates imaginable. That three percent upside seems pretty low to me.

On the other hand, under the bad or worse scenarios, if rates go back up to where they were three years ago, expect a soundly negative return, and if they go up quickly, the decline in value will be even more.

Avoid the bad hangover
In my opinion, many investors are in denial that the party is over, and are taking a few more shots of the bond nectar by buying lower quality and longer duration bonds. If memory of my college days serves, taking a few more shots before sobering up only makes the hangover worse.

My advice
Behaviorally speaking, people expect recent returns to continue through a dynamic called recency bias. As I've said, I don't know if intermediate and long term rates are going to increase next year, but I do know they can't continue to decrease at the same pace. Grab your coats folks, the party is over!

You should be buying fixed income as part of your rebalancing strategy now that equities have doubled from the March 2009 lows. What you shouldn't do is continue to expect the juicy past returns and, above all, don't chase yields by buying long duration and junk quality.

My own strategy to minimize any hangover is by buying certain CDs, with the plan being to cash them in and pay the early withdrawal penalty if rates do skyrocket. It's one of the very few advantages the small investor has. And don't hold your breath in anticipation of the financial industry telling you about them because, frankly, there is no financial incentive for them to do so.

More on MoneyWatch
Four CDs That Protect Against a Bond Bubble
CDs as Bond Bubble Protection - Revisited
What's Going on With Ginnie Mae (GNMA) Bond Yields?
  • Allan Roth On Twitter»

    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.

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