The dangers of the growing bond bubble

DESPITE A DECADE of bitter experience, we have learned little about the buildup and bursting of speculative bubbles. After the euphoric upward march of technolgy stocks and their subsequent collapse, we ignored signs of an

emerging housing bubble. We are still paying the price for the implosion of that overheated market, and will do so for many years to come.

Meanwhile, many signs point to the ballooning of a bond bubble. And that speculative swelling, which has been building since 2008, may be ready to burst, too.

Such has been the demand for bonds of all kinds in the past two years that yields have plunged to levels recently thought unimaginable.

The average yield on five-year Treasuries, for example, was 4.43% in 2007. In 2008, the yield dropped to 2.80% and was down to 2.2% last year.

Last week, it stood at 1.38%.

Yields on 10-year and 30-year Treasuries have fallen by comparable amounts.

In 2007, the average yield on a 10-year T-bond was 4.63%. Last week, it had fallen to 2.56%.

Yields on 30-year bonds fell to 3.71%, from 4.84%, over the same period.

In their rush to safety, Treasury investors have been willing to tie their money up for long periods in exchange for very little return.

Some may be betting that the Federal Reserve will play its hand perfectly and prevent erosion of the dollar’s purchasing power despite its huge injections of liquidity into the economy. Others apparently are more concerned about return of investment than return on investment.

Unfortunately, if inflation should rear its ugly head, interest rates will rise in response, and the bond bubble will burst. If that were to happen, investors would still receive their investment back if they held their bonds until maturity — but not in real terms, of course.

Worse, if they were to sell after rates rose, they would suffer a capital loss.

Those most exposed to the bond bubble are those who have been tempted by the higher yields of junk bonds and junk bond exchange-traded funds. Companies issued a record $14.3 billion of junk bonds during the week ended Aug. 13, and investors have snapped them up.

Although returns on junk also have been driven down as the demand for bonds has surged, the bonds still offer significantly higher yields than Treasuries or even investment-grade corporate bonds. While triple-A 10-year corporates were yielding 2.84% on Aug. 16, many junk bond issues could be found with yields greater than 7%.

For example, Toys R Us Inc. sold a seven-year bond yielding 7.5%. On average, 10-year junk bonds yield about 8.5%.

Like Treasury investors, junk bond owners could be hurt by inflation, which would drive down the price of their bonds as rates rose, as well as the value of their principal when — and if — it were returned.

But deflation also could damage junk bonds, as a slowing economy would make it more difficult for companies to maintain their profits and pay off their loans, increasing the likelihood of default. Junk bond investors, therefore, must hope that the Fed doesn’t allow the economy to overheat and become inflationary, or to cool too much and be-come deflationary.

Meanwhile, financial advisers must warn their clients not to get too carried away with bond investing, especially junk bond investing.

Familiar as we are with the tension between greed and fear in the equity markets, let’s not forget that the same dynamic applies in the bond market. In this bubble, those driven by fear into the Treasury market and those driven by greed into junk bonds both may suffer.