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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

MONEYWATCH ByMatt andTomReynolds


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.

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