Feb 25 2013
Another bubble? Remember the Y2K non-event? Since then we’ve had the dot com bubble, the housing bubble and the stock market bubble. Now, there’s even talk of a bond bubble (and that’s not the next 007 flick).
Stated simply, the “market value” of your bond holdings can drop if interest rates rise. I remember getting a call from my brother some years ago. He had just gotten a 401K statement showing his bonds gone down since the last report. He had moved out of stocks to avoid this and couldn’t figure out what was going on. I tried to explain and even over the phone could just feel his eyes glazing over!
Let me try again. Suppose you recently paid $100 for a brand new 10-year U.S. Treasury note (bond) that will pay you a whopping 1.5 percent interest per year. If you hold it to maturity, you’ll get that $100 (face value) back in full.
But what if prevailing interest rises to, say, three percent immediately after your purchase? You’ll continue to get your 1.5 percent every year, so that’s not a problem. And if you hold on for 10 years, you’ll get your $100 back.
The difficulty arises if you try to sell now. Nobody is going to pay $100 for your 1.5 percent bond when they can get a new one yielding 3 percent from the Treasury. The only way you can sell yours is by marking the price down closer to $87 so the buyer of your bond can earn the market rate of 3 percent.
If rates stay at 3 percent, the bond’s “market value” will gradually rise to the face value over the next 10 years. If rates fall, the price will rise faster. If interest rates climb higher, the bond price will drop even more. If that overnight jump was to 6 percent, the bond’s market value would drop to around $67 and then start climbing gradually.
So is there a bubble? Yes and no. According to the latest survey of economists by the Wall Street Journal, the 10-year Treasury is expected to yield 2.3 percent by the end of 2013 and 3 percent a year later. Hence, bond market values are likely to decline.
How might rising rates affect you? Not much at all if you bought your bonds for the income with plans to hold to maturity. However, if you need to get at the principal before maturity, then you could have a problem because you’ll have to pull out less than you paid.
The sensitivity to interest rate changes (aka “duration”) is higher for longer maturity bonds and lower for higher coupon bonds. Accordingly, the greatest sensitivity of market prices is for long maturity zero coupon bonds whose accumulated interest is paid at maturity.
Finally, there are huge differences between a potential “bond bubble” and something like the dot com fiasco. Many of those investors lost everything: there were no dividends and the shares became worthless as the firms vanished. Unless you’ve been buying some really risky bonds, this is very unlikely to happen.
Economic Review is published by Webster Financial Corporation. The opinions and views in this publication are those of Dr. Nicholas Perna, Webster’s economic advisor, and are not intended to provide specific advice or recommendations for any individual. Consult professional advisors with regard to your individual situation.
To read past editions of The Economic Review, please visit: WebsterBank.com/EconomicReview