Is the Bond Market Really Headed for Trouble?

Bond market

The talk of the bond market being in trouble, or at the very least undesirable, has been going on for a while. Bonds have gotten even more bullish lately, which is scaring them more.

While we could say that there are a lot of people who don’t really understand the stock market that well, most people, including most commentators, at least get the basics of this. You look to buy stocks and hope they go up and hopefully sell them later for a nice profit.

There is much more to investing in stocks than this of course, but if you do understand that the idea is for them to appreciate in value, you at least understand what the goal with stock investing is.

With bonds, we don’t even see this level of understanding among the general public and in the popular media, and when this is the case, we’re going to see a lot of pretty strange views out there, like people getting more and more worried as bonds increase in value. Bonds have been on a fabulous run over the last 10 months, and things are getting even better with them lately.

You would never know this though from reading most stories in the media about bonds, even in the financial media, who are at least supposed to have a little better understanding of financial markets than the typical man on the street. If neither understand bonds properly, we will end up with the blind leading the blind, as a lot of people read these articles and be anxious or even afraid of bonds.

At least some people know that bonds are traded and they might even know that when this happens, people make money when the price of bonds go up and they lose money when bond prices go down. They likely will see all this only really mattering to bond traders, perhaps like short-term swings matter only to stock traders, where the rest of us need to be focused on bond yields perhaps.

Bond prices matter to everyone who dabbles in bonds and does not do so with the exclusive purpose of buying them at the current market price and holding them to maturity no matter what. Even with people who are completely committed to this strategy though, bond prices should matter a lot anyway, especially in a low yield environment such as what we have these days.

Investing in bonds to maturity no matter what might seem like a good approach or even the best approach to some, but if we just focus on this to the exclusion of other options, we can end up cheating ourselves out of better returns and even make some real mistakes.

Let’s look at all the talk out there about how low the yields are on treasuries. Maybe we saw the 10-year treasury bill yield 2.5% around the first of May of this year and thought that yield too paltry to attract our interest. If we’re going to hold these treasury bills for 10 years, maybe that’s not all that great of a return so some may think that this thinking at least makes some sense.

Perhaps we watched the yields drop from here to 2% and now to around 1.7 and maybe even feel happy about our decision to not buy them. As crazy as this may seem, there are some investors who even think that declining yields is a bear market for bonds because they are focused on yields so much.

These investors should actually be kicking themselves because the reason why these bonds have seen their yields decline this much in a little over a quarter is because these bonds are worth a lot more now than back then. If you entered back then you would still have your 2.5% yield and have made some real money on the treasury bills since then and even could sell them here for a nice profit.

Deciding on Bonds Based on Yields Isn’t a Good Approach at All

Yields only matter once during a bond trade, at the time of purchase, and only matter if you are going to hold them to maturity, in this case until May 2029. There are some people who buy 10-year bills and might not even be alive to see them mature, but even if they are, they still need to examine whether doing that would be the right approach or even a good idea at all.

We cannot decide this in isolation, where the choice somehow becomes to hold them to maturity or not invest in them at all. Even if we consider ourselves very conservative investors who would not even touch stocks with a 10 foot pole, this does not mean that we want to trim the length of the pole we’re touching bonds with way too short, or in this case, just toss it into the water altogether and put our hands together and just hope that fate will be kind to us.

While interest rates and inflation are historically low right now, where around 2% might even seem decent, we really don’t know all that much about how things will play out during the next 10 years, and certainly not during the next 30 if we are looking at 30-year treasury bonds, which is a popular investment as well.

When we commit ourselves to such a strategy, we’ll call it the buy and hold treasury approach, we actually expose ourselves to the full risk of the market. We’ll end up with our 2% yield in this case, or whatever the yield ends up being when we enter, but how much this income stream ends up being worth in real dollars is yet to be determined, and the story won’t be told until maturity, many years from now.

If interest rates rise quite a bit, as they certainly can, our real return net of inflation will become trashed and the value of our treasuries will be as well. We might think that this does not matter if we hang on to them until the very end, but our whole position, the principal amount we paid for the bond and the interest we earned, all become subject to the risk of devaluation from inflation.

For example, if we bought a 2% yield over 10 years and inflation averaged 4% over this time, we’ve just lost quite a bit of money from this deal, 20% in fact net of inflation. If we start with $10,000, we’re only going to end up with $8000 at the end of the 10 years even after we add in all of our interest payments. That’s not a very good deal at all by any measure.

Bond yields tend to be pretty close to inflation at the time we buy them, a little above it with the 10 year on average. If inflation is pretty low like it is now, we need it to stay this low throughout the term of the bond, just to keep this slight advantage and net real return. As inflation rises from here, this means that we’ll be penalized by that amount.

We may then wonder why anyone would invest in bonds in a low inflation environment, but we will only think this if we see this as the only real way to invest in bonds. If we were considering negative yield bonds like we see in Europe these days, our ever doing this would just seem crazy, but once again, only in terms of our assumption of thinking that only the yield matters, or that it really matters at all.

We Can’t Escape Risk with Bonds, But We Can Choose to Manage It

Whenever we plan on not holding bonds until maturity no matter what, and actually consider the movement of our bonds over time, this is where we may start to understand that the bond market really isn’t about yields at all, it’s actually about how their prices move. This is why so many people buy negative yielding bonds, and we’re now up to $15 trillion worth of them out there right now worldwide.

There are some out there these days who even think that treasury bills will go to zero yield or even below zero at some point in the foreseeable future. If we knew that this would happen, we should run, not walk, to buy more bonds, because this will drive their value up a lot and we can make quite a bit of money from this on top of the 1.7% that they now pay in reference to our purchase price.

The best time to invest in bonds is when yields are falling because that means that the value of bonds are rising, and like with stocks, it’s just better to buy low and sell high. This will require us to do something that a lot of investors find scary, and that’s to look to time our investments, but the real rewards go to those who actually invest for the times and not just prefer a mindless approach that requires neither effort or thinking.

There are strategies out there that do not require either, and you can indeed just hang on to your positions come what may, but if we do choose this, we at least need to ask ourselves why this would be a good approach.

The bond market isn’t crashing and is doing quite the opposite, as we have a bull that is stampeding lately and is making a lot of people a lot of money. You don’t get the returns with bonds like you do with stocks unless you are well leveraged, but that’s the part to be left to the bond traders, but this does not mean that investors who just buy bonds with cash can’t get in on the fun as well.

When doing this, we no longer care so much about yields and instead focus on bonds the way we focus on stocks, rooting for their price to go up and getting out when it reverses direction in a manner that should tell us that the ride is over and we should be looking for another way to make money, because all we’ll be doing is losing when prices fall and yields rise.

Even with bond prices so high, this doesn’t mean that the rally is over, no more than higher stock prices means that their bull market is over. We will know when it all ends, when it ends, but this can only be used to our advantage if we actually are paying attention and are ready to act when needed.

The upside with bonds is much more limited than with stocks, but this does not mean that bonds do not have more upside from here even with prices where they are now. If we can make some good profit every time Trump sends one of his famous tweets that gives the stock market shivers, when they shiver, bonds usually benefit, and those who are holding them may benefit as well but only if they are approaching this as a real investment and acting like real investors.