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Hoisted from the Archives from Four Years Ago: What is Happening with Bond Prices?

What is Happening with Bond Prices?: August 18, 2010:

It is very hard to have a bubble in bonds because there is a date certain at which the principal is repaid. In year nine you cannot delude yourself into thinking that somebody will pay more than face value in year ten. And so in eight it is very hard to delude yourself into thinking that somebody in year nine will delude themselves into thinking that somebody will pay more than face value in year ten.

Nevertheless, Jeremy Siegel and Jeremy Schwartz think that we are in a bond bubble:

The Great American Bond Bubble: If 10-year interest rates, which are now 2.8%, rise to 4% as they did last spring, bondholders will suffer a capital loss more than three times the current yield. Ten years ago we experienced the biggest bubble in U.S. stock market history.... A similar bubble is expanding today that may have far more serious consequences for investors. It is in bonds, particularly U.S. Treasury bonds. Investors, disenchanted with the stock market, have been pouring money into bond funds, and Treasury bonds have been among their favorites.... We believe what is happening today is the flip side of what happened in 2000. Just as investors were too enthusiastic then about the growth prospects in the economy, many investors today are far too pessimistic....

From our perspective, the safest bet for investors looking for income and inflation protection may not be bonds... stocks, particularly stocks paying high dividends, may offer investors a more attractive income and inflation protection than bonds over the coming decade.... Today, the 10 largest dividend payers in the U.S. are AT&T, Exxon Mobil, Chevron, Procter & Gamble, Johnson & Johnson, Verizon Communications, Phillip Morris International, Pfizer, General Electric and Merck. They sport an average dividend yield of 4%, approximately three percentage points above the current yield on 10-year TIPS.... Their average price-earnings ratio, based on 2010 estimated earnings, is 11.7, versus 13 for the S&P 500 Index. Furthermore, their earnings this year (a year that hardly could be considered booming economically) are projected to cover their dividend by more than 2 to 1....

Those who are now crowding into bonds and bond funds are courting disaster.... If over the next year, 10-year interest rates, which are now 2.8%... rise to 4% as they did last spring, the capital loss will be more than three times the current yield. Is there any doubt that interest rates will rise over the next two decades as the baby boomers retire and the enormous government entitlement programs kick into gear? With future government finances so precarious, private asset accumulation and dividend income must become the major sources of retirement funding. At current interest rates, government bonds will not be the answer...

A bubble--I thought--is when those holding an asset do so because they expect its price to rise more-or-less indefinitely, and such a price rise is impossible. Such a bubble is very prone to rapid collapse when people realize that their expectations are very wrong.

Do holders of U.S. Treasury bonds expect the prices of the assets they own to rise more-or-less indefinitely? No, they do not. They expect their holdings of Treasury bonds to be and to continue to be safe places to park their money, and they expect other asset classes to be risky.

Over time, I think, the fear of other asset collapses will ebb--but this is highly likely to produce a gradual rise in the prices of other asset classes and a gradual fall in Treasury prices, but a gradual fall does not make Treasury bonds unsafe.

Those who hold Treasuries to maturity will get the returns they expect: for holders-to-maturity, Treasury bonds are indeed very safe absent a very unlikely upward leap in inflation.

So I cannot see any possibility of a bubble collapse at the short end of the Treasury market--less than ten years, seven.

But how about the spectrum from seven years on out to thirty? Could there be a sudden large downward movement in Treasury bond prices that would convince holders of Treasuries that they are not safe at all and induce a wave of panicked selling that would look like the collapse of a bubble?

In asset prices, never say never: the only thing you can ever say with absolute certainty is J.P. Morgan's: "they will fluctuate."

But I don't think so. People today buy an on-the-run ten-year Treasury at a yield of 2.64%--the bond with a 2.65% coupon maturing on August 15, 2020 at a price of 100.07. Its price drops tomorrow to 88.96. Do they conclude that their long Treasury position is too risky to hold? Or do they conclude that the Treasury correction has come and gone, and that Treasuries are actually safer than ever?

To argue that there is a Treasury bond bubble going on, you have to believe that such a fall in Treasury bond prices would induce further selling. And I cannot see that--not with the current state of macroeconomic news.