Are Bond ETFs Safe If The Bond Bubble Bursts?

“When everyone thinks central bankers, money managers, corporate managers, politicians or any other group are the smartest guys in the room, you are in a bubble.” 

 – Doug Kass, TheStreet.com

There’s been considerable debate amongst bond aficionados as to whether the bond market is in the midst of a bubble.Investopedia.com defines a financial bubble as follows:

“A bubble is … characterized by the rapid escalation of asset prices followed by a contraction. It is created by a surge in asset prices unwarranted by the fundamentals of the asset and driven by exuberant market behavior. When no more investors are willing to buy at the elevated price, a massive sell-off occurs, causing the bubble to deflate.”

Let’s apply that definition to the current state of the bond markets. Although interest rates have risen this past week, there’s no doubt that as rates have plummeted to all-time lows bond ETF prices have risen rapidly — especially during the last couple of months (see table below).[1] 

(Click on image to enlarge)

What’s less clear is whether the second part of the bubble definition is satisfied, namely, that the surge in bond prices is unwarranted. Some analysts assert that the continued decline in interest rates is justified by the low rate of inflation, worsening economic conditions, and accommodative monetary policies by central banks around the globe.

Others argue that interest rates have fallen well below levels that are justified by economic data. They advise that central banks have gotten carried away with “quantitative easing” programs that involved cutting interest rates and buying bonds in the name of stimulating growth. Cash began to pour into the bond market as pension funds, insurance companies, and similar institutions that rely on long-term debt sought to lock in rates before they fell further. Inevitably, speculators joined in, hoping to make a quick buck by flipping long-term bonds, and the bond bubble was born. 

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