Bond Market: Are You In For Big Losses?

As interest rates continue to decline, could you be setting yourself up for big losses if you invest in bonds at these low rates?

Jeremy Siegel, the Wharton finance professor and long term stock market bull, comments in The Wall Street Journal that yes, the bond market is a huge bubble ready to burst, similar to what we saw with stocks at the height of the internet frenzied 1990s. Yes, rates are low and will likely go higher as the economy recovers. But are low interest rates the same thing as a bubble in stock prices?

Let's go back to 1999 and think about how we were so willing to invest our hard earned money into technology companies that were trading at crazy valuations of 50 to 100 times their earnings. Although the valuations were clearly out of whack (with the benefit of hindsight), investors thought that the growth prospects were so phenomenal that if they bought an expensive stock at $100 a share, they could eventually sell it for $200 a share. There was an illusion of ever rising stock prices that fed the mania.

But think about how different this is with fixed income investments. If you go to the bank and buy a 5 year FDIC insured CD that pays 2.0% interest, how much money do you think you'll make on that CD each year? Well, it's obvious, you'll make 2.0%, nothing more and nothing less. There's no illusion that somehow this CD will pay you 10% a year in interest. Investors know what they're getting. That's different than buying a $100 stock and believing it can somehow go to $200 next year, then watching it sink to $5.

Investors clearly see the low return they're getting in the fixed income markets and are choosing these low rates in the face of an always present inflation threat. The inflation of the mid 70s and early 80s is still a painful memory for many investors, and the bond market knows that inflation can ravage fixed income investments. Yet, people still buy them and are consciously accepting a low rate of return.

• When investors bought tech stocks in the 1990s, they weren't expecting low returns. They expected gang-buster returns regardless of how much they paid for the stocks. Thus, a classic bubble emerged.

So why are people willing to invest their money in fixed income at these incredibly low rates? Collectively, from all the corners of the globe, people are buying low interest bearing investments without any illusion of what their returns will be for the term of those bonds.

Maybe it's an uncertainty hedge. And by that I mean the global markets have never been as uncertain as they are now for the majority of investors. So to hedge against another potential big stock market decline or deflationary cycle, they're willing to accept low returns on their money in exchange for the promise of the return of their money. That may be pretty rational given the global economic circumstances.

If the economy recovers faster than currently anticipated, then these low interest rate investments won't look so good as rates rise and we see some inflation in the economy. But if the future looked that certain, then rates wouldn't be this low.

• And remember, if you buy and hold high-quality fixed income securities, such as US Treasury bonds, you'll get your money back plus interest. Is that a bubble, or just the cost of protecting your principal during these economic times?

It's really a question of how much risk you want to take with your savings. You can wing it with a 100% bet on the future of stocks, and in the long run, you'll probably do well. But as John Maynard Keynes is credited with saying, "in the long run, we're all dead." And maybe that has some people concerned.

Bottom line. For a part of your portfolio, it's usually prudent to be more concerned with the return of your money than the return on your money. Maybe more investors understand that today than they did 10 years ago.

Above material does not constitute investment advice; consult your individual financial advisor prior to making any financial decisions.
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