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What You Should Know About the "Bond Bubble"

The financial media is spewing out an awful lot about the bond bubble. The implication is that somehow the market has made a huge pricing error and has overvalued bonds. The message delivered by the doomsayers is to avoid maturity risk as the bubble will surely burst and you'll be stuck holding very low yielding bonds.

Clearly, there has been a massive inflow of funds into bonds, on the order of hundreds of billions of dollars. And investors chasing performance can certainly be a sign of a bubble, or extreme overvaluation. For example, performance-chasing led to the price-to-earnings ratio of the S&P reaching well over 40 at the turn of the century. This meant that the earnings yield on stocks (E/P ratio) was approaching 2 percent, while the real yield on TIPS was about twice that. Clearly there was a bubble in stocks. However, today's yields on bonds can be telling an entirely different story. Let's take a look at the three factors that determine the yield on Treasury securities.

Outlook for Inflation As I've mentioned before, no matter which measure of expected inflation we use, the forecast is for inflation to be well below its historical average of 3 percent. As I write this, the break-even rate of inflation between five-year Treasuries and five-year TIPS is just 1.27 percent, and it's just 1.59 percent for 10-year TIPS. That's one reason nominal yields are very low.

Demand for Borrowings The demand for credit is way down for several reasons. First, the savings rate has risen dramatically as consumers rebuild their balance sheets. Second, corporate balance sheets are healthy. Corporations are sitting on record amounts of cash or other liquid assets. (They had almost $2 trillion at the end of March 2010.) Combine that with a weak economy, the weakness in the housing and commercial real estate markets and capacity utilization at just 74.8 percent, and there's little need for corporations to borrow for investment purposes. With little demand for credit, real interest rates are very low.

Risk Premium for Unexpected Inflation The market's perception is that there's currently little risk of unexpected inflation, and some even think that deflation is the greater risk. Hence the risk premium (which we can't directly observe) is probably very low, or perhaps even non-existent.

The bottom line is that the very low yields we see for Treasury and other government securities is very logically explained by economic factors. In fact, some of the very same people who have declared we're in a bond bubble were saying the same thing a year ago when rates were much higher, which provides just another example of why you should ignore all market forecasts. Instead, you should have a well-designed plan for your fixed income assets and adhere to that plan.

More on MoneyWatch:
How to Hedge Both Inflation and Deflation The Only Guide You'll Ever Need for the Right Financial Plan Why the Cost of Cash Is High Roth IRA Conversions: Why All the Fuss? The Truth About Municipal Bond Costs

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