Bond bubble?
One of the odder ideas I've seen in the news lately, is that there is currently a bubble in the bond market. I strongly suspect this is the result of folks who either misunderstand what a bond is, or what a bubble is; interestingly five years ago, many of them were assuring us a housing bubble was impossible.
Let's start by discussing what a bubble in the financial markets is. A bubble happens when people are convinced that the price of something (.com stocks, real estate, gold) can only go up, and will never go down, so you're guaranteed of a profit. Easy!
So, why is it difficult to see a bond market bubble? Let's look at what a bond is. Essentially, a bond is a loan, made in such a way that it's easy for investors to swap it for cash now. It has a face value, a coupon rate, and an expiration date. At expiration, the bondholder receives the face value; until then, at defined periods, the bondholder receives interest payments, based on the interest rate.
Now, when a bondholder wants to get his investment back, he can sell the bond on the bond market. Depending on the market interest rate that millisecond, he might receive more or less than the face value. If the market rate is more than the coupon rate, he'll receive less than the face value; if the market rate is less than the coupon rate, he'll receive more than the face value.* From this, we can see that both capital gains and capital losses are possible.
But it takes more than this to sustain a bubble worthy of the name. It takes the irrational belief, in investors that control vast sums of money, that there's a fortune to be made. And it has to be made quickly, because that bond expires on a well-defined date. And, remember, to make that capital gain, the interest rate has to go down after you buy it. Aaaaand, what are interest rates like now? (Hint: The answer is "Pretty close to the lowest they've been since the bond was invented, in or not long before 1623.") As of close of business on July 30, 2010, the Feds were paying an average interest of 2.471% on all marketable bonds; that's a weighted average of every bond that's been issued since August 1980 (when the prevailing interest rate was 12.91%), and not yet redeemed.
So, what's behind the "bond market bubble" talk? Some of these folks, having been caught napping for the .com and housing bubbles, are determined to atone by crying "bubble!" every time they think an asset class is overpriced. Many are the folks who have been screaming "Hyperinflation is right around the corner! Any Day now!" for more than two years now. And some have a political interest in having voters terrified on November 2, 2010. Plus, of course, there are some who don't know nearly as much as they think they do.
* The difference is calculated so that, if the buyer holds to maturity, the interest payments and the face value will add up to the same amount as the buyer would receive, if he paid the face value and the coupon rate was the same as the market rate at time of sale. This was "fun" to calculate, with pencil and paper, when I was taking Accounting 2, so long ago that calculators were not allowed on tests.
Let's start by discussing what a bubble in the financial markets is. A bubble happens when people are convinced that the price of something (.com stocks, real estate, gold) can only go up, and will never go down, so you're guaranteed of a profit. Easy!
So, why is it difficult to see a bond market bubble? Let's look at what a bond is. Essentially, a bond is a loan, made in such a way that it's easy for investors to swap it for cash now. It has a face value, a coupon rate, and an expiration date. At expiration, the bondholder receives the face value; until then, at defined periods, the bondholder receives interest payments, based on the interest rate.
Now, when a bondholder wants to get his investment back, he can sell the bond on the bond market. Depending on the market interest rate that millisecond, he might receive more or less than the face value. If the market rate is more than the coupon rate, he'll receive less than the face value; if the market rate is less than the coupon rate, he'll receive more than the face value.* From this, we can see that both capital gains and capital losses are possible.
But it takes more than this to sustain a bubble worthy of the name. It takes the irrational belief, in investors that control vast sums of money, that there's a fortune to be made. And it has to be made quickly, because that bond expires on a well-defined date. And, remember, to make that capital gain, the interest rate has to go down after you buy it. Aaaaand, what are interest rates like now? (Hint: The answer is "Pretty close to the lowest they've been since the bond was invented, in or not long before 1623.") As of close of business on July 30, 2010, the Feds were paying an average interest of 2.471% on all marketable bonds; that's a weighted average of every bond that's been issued since August 1980 (when the prevailing interest rate was 12.91%), and not yet redeemed.
So, what's behind the "bond market bubble" talk? Some of these folks, having been caught napping for the .com and housing bubbles, are determined to atone by crying "bubble!" every time they think an asset class is overpriced. Many are the folks who have been screaming "Hyperinflation is right around the corner! Any Day now!" for more than two years now. And some have a political interest in having voters terrified on November 2, 2010. Plus, of course, there are some who don't know nearly as much as they think they do.
* The difference is calculated so that, if the buyer holds to maturity, the interest payments and the face value will add up to the same amount as the buyer would receive, if he paid the face value and the coupon rate was the same as the market rate at time of sale. This was "fun" to calculate, with pencil and paper, when I was taking Accounting 2, so long ago that calculators were not allowed on tests.