Headlines about a bond market meltdown are catching fire all over the world. In the UK, The Telegraph recently reported British pensioners could face a 50 percent portfolio decline if there’s a bond market correction. Others, like David Roche president of Independent Strategy, suggested to CNBC that bonds are currently the most dangerous asset class to own. Scott Burns agrees.
When we hear about bond bubbles, what does that mean? Of course, the price of any asset (whether gold, stocks or bonds) is based on supply and demand. And the demand for bonds is bubbly. It has pushed bond prices to multi-decade highs.
Examining a single bond index, like Vanguard’s Total Bond Market Index, provides a clear explanation of what has happened. Unlike stocks, bonds (as a group) don’t appreciate in price over the long term. You buy a bond, hold it to maturity, collect the interest along the way, and receive your principle back when it matures.
A bond index pays interest to shareholders, while its price simmers within a narrow range. The table below shows historical prices for Vanguard’s Total Bond Market Index fund. Notice its price stability:
Price Stability in a Major Bond Index fund
|June 1992||$9.88||June 1998||$10.13|
|June 1994||$9.39||June 2000||$10.04|
|June 1996||$9.55||June 2006||$9.68|
|Source: Yahoo Finance|
Halfway through 2010, however, its price hit $10.57. It continued to rise, exceeding $11.20 in 2012. As I write, it’s trading at $11.08.
This is 14.4 percent higher than the index’s price just seven years ago. But bonds aren’t supposed to be a source of capital gains. Something has to give. If the bond index drops to its historical range—and I can’t see why it wouldn’t—investors will lose money. Paltry interest payments would be little consolation.
The question, of course, is how do you protect yourself from a pending bond correction?
Selling bonds in favor of a 100 percent equity portfolio reduces diversification. That’s never a good idea. So let me present three possible solutions, or a combination of the three.
You might want to consider Vanguard’s Short Term Bond Index. It’s priced only 8 percent higher than it was seven years ago. But yielding only 1.39 percent, it’s clearly no panacea.
Other investors may opt for cash in a money market fund. The yield is practically zero, but if bond prices plunge, cash rich investors could revel. Lower future prices, of course, will mean higher interest yields. A third solution could be splitting your fixed income into thirds: one third in a short term bond index, one third cash, and one third in an international bond market index, which Vanguard hopes to launch soon.
Vanguard’s rationale is this: international bonds comprise 33 percent of the total global capital market. That’s a higher global weighting than U.S. or international stocks. So in Vanguard’s view, they belong in a diversified portfolio. For this reason, Vanguard intends to include the index in their Target Retirement funds.
The yield might be higher than a domestic bond index, but there’s a wrinkle that is likely to reduce that benefit. Vanguard intends to currency hedge its international bond index with the goal of lowering currency risk.
While currency hedging often reduces volatility, it almost always reduces long term returns. Wanting exposure to the U.S. stock market—while attempting to avoid currency risks-- Canadian fund providers have offered currency-hedged products for years. Unfortunately, hedging currencies has a cost that can reduce returns as much as 1 percent each year.
An un-hedged international government bond ETF (ISHG) might fit the bill, if you can handle its stomach churning volatility.
There’s no comfortable solution to the bond market dilemma: You can choose your rock, or choose your hard place.
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas