This page contains a Flash digital edition of a book.
Is the Bond Market a Bubble Ready to Burst?


THERE HAS BEEN A LOT OF DISCUSSION LATELY about the bond market being the next bubble to burst. While the media likes to talk about bubbles bursting, as sensation sells, we try to approach analyzing markets with less sensationalism and more of a “what are the risks, and how can I protect against those risks” approach. At the very heart of this discussion is interest rate risk. Interest


rate risk is defined as the risk that an investment’s value will change with an overall level of change in interest rates. The market value of fixed income investments (bonds, notes, etc.) changes with the fluctuation in interest rates. As interest rates increase, the value of outstanding fixed income investments will fall. To illustrate why this is the case, consider this example. A


corporation issues a bond at 5%. Interest rates rise subsequent to this issuance and now another corporation with a similar balance sheet and credit rating issues a new bond and has to pay 5.5%. The value of the first bond issue is less now because an investor can buy the new bond and make 5.5%. The same is true, of course, for the inverse. Namely, if interest


rates fall, the value of outstanding fixed income investments should rise, all other things being equal. The interest rate cuts from the Federal Reserve, which began in September 2007, have brought the federal funds rate (the rate at which banks lend to each other on an overnight basis) from 5.25% to essentially zero by December 2008. This has been a great period for fixed income; however, we are now at historic interest rate lows. As of this writing, the 10 Year United States Treasury has a current yield of 2.90%, the Barclays aggregate bond index has a yield of 1.92%, the brokerage money markets yield a minute 0.03% (yes, that is 3/100th of one percent), and 12 month CD’s are yielding 0.45% (less than a half of one percent). With rates at these levels, most investment analysts predict that rates will be increasing in the future. That is pretty much a


certainty. What is not so much of a certainty is when this will occur. We believe traditional fixed income (whether it be fixed rate US Treasuries or Investment Grade Corporates) to be an


unattractive investment at present levels given the low yields and risk of loss of value when interest rates ultimately rise. Does this meanwe are selling all fixedincomepositions inour clientportfolios? Absolutely not. We have already indicated that we do not know when rates will begin to rise. It could be six months or two years. In addition, income is only one reason we allocate to fixed


36 January 2011 | LIFESTYLE njlifestyleonline.com


MONEYWATCH ByMatt andTomReynolds


L I F E S T Y L E


income. The other primary purpose for an allocation to fixed income is for safety of principal and less market risk than equities. In addition, not all areas of fixed income are as sensitive to interest rates as Treasuries and fixed corporate rate bonds. For the past several years we have been allocating assets to


inflation protected securities or “TIP’s. Typically a rise in interest rates coincides with a rise in inflation. As these securities get adjusted upwards for inflation, they can act as a hedge against rising rates and inflation. However, this asset class has done very well over the three of the last four years, so we believe the best returns are behind this asset class for a while. Another place we have been placing new money in the fixed


income arena is in foreign bonds, both developed and emerging nations. The developed nations give us access to investment grade corporate debt that is not US dollar denominated and although this asset class has performed well eight out of the last nine years, the bearish outlook on the US dollar due to heavy deficits and soaring national and local government debt appear to be enough to keep this asset class attractive. The emerging market fixed income is attractive due to the high


growth rates and surplus economies in the emerging markets. In addition, having another asset class that is not dollar denominated is an added benefit. In summary, we do not believe the answer to countering


the risk of bond devaluation is a mass exodus strategy, rather we encourage a deployment of capital across several categories of fixed income (Corporate, government, foreign, floating rate, and high yield) and encourage a laddering of maturities (with greater emphasis in shorter maturities). As for the bond bubble, by their nature, bubbles usually don’t have a lot of predictors and with all of the people pontificating about the next bubble to burst, that leads us to believe we most likely won’t see anything spectacular like the dot com bust or the financial crisis of 2008. We just expect interest rates to rise over multiple years and believe people should prepare their portfolios accordingly.


— —Matt & Tom Reynolds


This article is for informational and educational purposes only and should not be relied upon as the basis for an investment decision. Consult your


financial adviser, as well as your tax and/or legal advisers, regarding your personal circumstances before making investment decisions.


Page 1  |  Page 2  |  Page 3  |  Page 4  |  Page 5  |  Page 6  |  Page 7  |  Page 8  |  Page 9  |  Page 10  |  Page 11  |  Page 12  |  Page 13  |  Page 14  |  Page 15  |  Page 16  |  Page 17  |  Page 18  |  Page 19  |  Page 20  |  Page 21  |  Page 22  |  Page 23  |  Page 24  |  Page 25  |  Page 26  |  Page 27  |  Page 28  |  Page 29  |  Page 30  |  Page 31  |  Page 32  |  Page 33  |  Page 34  |  Page 35  |  Page 36  |  Page 37  |  Page 38  |  Page 39  |  Page 40  |  Page 41  |  Page 42  |  Page 43  |  Page 44  |  Page 45  |  Page 46  |  Page 47  |  Page 48  |  Page 49  |  Page 50  |  Page 51  |  Page 52  |  Page 53  |  Page 54  |  Page 55  |  Page 56  |  Page 57  |  Page 58  |  Page 59  |  Page 60  |  Page 61  |  Page 62  |  Page 63  |  Page 64  |  Page 65  |  Page 66  |  Page 67  |  Page 68