Date: 6/28/2010
Author: John Radtke

Bond Market Bubble Fears May Overlook Secular Trends

Much recent press has been devoted to warnings of bonds as the next potential market bubble. The rationale typically revolves around ‘excess allocation’ to bonds and bond funds by investors during the past 18 months. With fixed income securities attracting allocations previously weighted to equities and higher risk assets, bond buyers are being cautioned not to reach for yield near cyclical lows.

A recent article in Financial Times makes an anti-bubble case for bonds. David Rosenberg, chief economist and strategist at Gluskin Sheff & Associates, cites several key variables which may account for continued inflows into bonds.

First, there are 78 million baby boomers in the U.S. with an average age of 54. These boomers will increasingly be likely to invest for capital preservation and income in the coming years. With memories of two bear markets in equities within the past decade, capital appreciation is less likely to be a major goal for this cohort.

The second key factor is the overall percentage of allocation for U.S. household assets. Until recently, about 60% of the overall U.S. asset mix has been about evenly split between equities and real estate, with less than 10% in bonds. The percentage allocation to bonds is highly likely to expand in the coming decade. The anti-bubble view is that secular increase in demand for fixed income securities will counter the expected increase in supply from private and government sectors.

With potential inflation on the minds of many bond bubble enthusiasts, will new bond buyers regret locking in current yields? Rosenberg deflates the inflation argument by making the case that deleveraging cycles typically last as long as seven years, and the current cycle is only at year two.

The deleveraging trends worldwide come at a time when most measures of underlying inflation are 1-2%. The deflationary forces of debt consolidation provide medium and long-term bond buyers with at least a modest yield pick-up over core inflation rates.

For holders of individual bonds, an additional anti-bubble point is simply that bonds have a stated interest maturity date and pre-set interest payment dates. A bond that matures at a known date with a known value cannot be judged in the same context as assets with no defined maturity value.

Certainly there are several risks when considering bonds in any environment, including credit risk and interest rate risk. However, investing in a laddered portfolio of high quality fixed income securities is a strategy for all seasons, offering shelter from market cycles and bubble talk.



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