Updated Monday, July 28, 2014 as of 8:23 AM ET
Why Bond-Bubble Fears Are Overblown
Wednesday, May 14, 2014
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Last year, bonds declined in value, and some surveys revealed that advisors were reducing their bond allocations.

It seemed certain that the Federal Reserve’s tapering of quantitative easing would lead to higher rates. Many predicted the imminent collapse of the bond bubble as investors pulled money out of bond funds. The Pimco Total Return Bond Fund (PTTRX) alone had $41 billion yanked, causing it to lose its title as the world’s largest fund.

While the iShares Aggregate Bond Fund (AGG) declined 1.98% last year, it gained 2.2% through April 12 of this year. What happened was simple.

First, many confused knowledge with unique knowledge. Markets are not stupid and knew the government couldn’t buy its own Treasury bonds indefinitely. Economists, however, have a track record of predicting the direction of longer-term interest rates less accurately than a coin flip.

The second, and even more important, aspect was that bubbles can happen only to risky assets. Yes, bonds lost nearly 2% last year, but stocks have lost 2% on several days this year.

During a shock to the system in which rates on a high-quality intermediate-term bond rose from 2.3% to 6.3% (400 basis points), the AGG bond fund lost about 18.1%. Still, that is less than the stock market lost on Oct. 19, 1987, alone. Unlike with stocks, a bond fund is a laddered portfolio. That 400-basis-point increase means that bonds yielding 2.3% are maturing every month and being replaced with bonds yielding 6.3%. Ultimately, the bond returns will increase for those who don’t panic and sell.

Never forget that stocks are riskier in a day than high quality bonds are in a year. The role of the bond portion of a portfolio is that of a shock absorber. Fear of bond bubbles shouldn’t drive your asset allocation.

Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes for CBS MoneyWatch.com and has taught investing at three universities.

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(3) Comments
How naive!
Posted by Gerard S | Thursday, May 15 2014 at 11:51AM ET
"Bubbles can only happen to risky assets?" That is a joke, or....a very foolish idea posited by someone who should think before they write. The wrongful assessment of risk is always part of a bubble (remember it is "different this time" in 2000 and houses always go up in value in 2007). Investing is always about expected return on investment and the risks involved. Bonds can fail to keep up with inflation for very long periods of time and that is their true risk.
Posted by Ted S | Thursday, May 15 2014 at 12:50PM ET
There are many strategies that can be utilized to manage a bond fund. Laddering is only one of them. Have you ever hears of a "barbell" strategy? If that is utilized, it could be much more volatile. Know what you are buying before you buy it
Posted by David W | Thursday, May 15 2014 at 2:54PM ET
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