“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. 

Knowing in real-time whether a financial market is experiencing a bubble is tricky; skillfully predicting when a market bubble will pop is even harder. Tadas Viskanta puts it this way in his book Abnormal Returns: Winning Strategies from the Frontlines of the Financial Blogosphere:

“The great challenge of bubbles is that they can really only be identified in hindsight. A bubble-like market can remain aloft far longer than its detractors can believe. As long as the market’s apogee is still unknown, there is always a ready source of market defenders. It takes the passage of time and a clear peak in price to convince the vast majority of market participants that a bubble did indeed take place.”

Be that as it may, one thing seems clear (at least to me) – the unprecedented fall in interest rates has significantly increased the risk of the bond market turning bearish in the not-too-distant future. After all, the amount of global government debt bearing yields below 0% are at about $17 trillion.[1]I find it hard to comprehend a fundamental basis for such a massive amount of negative-yielding debt.

Bond ETFs

It goes without saying that bonds and other fixed-income investments are a critical component of a diversified portfolio. How a bear market for bonds will impact your portfolio depends in no small measure on how you invest in bonds.  

In the past, individual investors’ exposure to the bond market was obtained by and large through individual bond ownership. The advent of bond ETFs changed all that. Bloomberg estimates that investors have poured approximately $672 billion into fixed income ETFs as of January 2019, $97 billion of which came in 2018 alone. 

There are many reasons why bond ETFs have become so popular. As compared to individual bonds, fixed-income funds offer investors broader diversification and greater liquidity. Bond funds also avoid the high mark-ups often incurred when buying individual bonds. Moreover, because bond ETFs are traded as shares, they also work well with rules-based investment strategies.

Bond ETFs also have their drawbacks. Perhaps the biggest is the absence of a fixed maturity date. A typical bond index ETF does not always hold the underlying securities till maturity. Instead, most bond ETFs sell their bonds as they get closer to their maturity dates and reinvest the proceeds to maintain a constant target duration. This is necessary to keep the bonds held by the portfolio consistent with an ETF’s stated objective over time. Since a bond ETF does not hold the securities until their maturity, there is no guarantee that ETF shareholders will recover their principal investment, as they would with a traditional bond (assuming the issuer does not default). 

A second concern is that bond ETFs are more susceptible to panic selling during bear markets. The fact that the future value of most bond funds is uncertain, combined with the ease of trading bond ETFs like shares of stock, could make the funds vulnerable to decisions driven by fear. By comparison, owners of individual bonds can wait out a market downturn, knowing that they will receive their original investment back (assuming the issuer does not default).

Some have also suggested that traditional bond ETFs are also vulnerable to liquidity risk if interest rates rise sharply. That’s because bond managers rely on institutional traders – so-called authorized participants or APs — to provide the liquidity needed when an ETF redeems or issues large blocks of shares.

Without getting into too much detail, ETFs and APs buy, sell, and trade bonds to one another when there is an imbalance of orders for ETF trading. These transactions occur in what is referred to as the “primary market”. 

A bond ETF’s liquidity is a reflection (in part) of an ETF manager’s ability to buy bonds in the primary market when the ETF issues new shares, and to sell bonds in the primary market when shares are redeemed. If bond prices enter a free-fall, APs could be reluctant to buy bonds from ETF managers for fear they won’t be able to resell the bonds before prices fall further. In that event, the price at which the ETFs shares trade on secondary markets, such as the New York Stock Exchange or Nasdaq, could fall below the net asset value of the bonds held by the ETF. 

Preventive Measures

A rather easy way to limit the impact a bear bond market has on investments in bond ETFs is to rotate the investment from a traditional perpetual maturity date ETF to a defined maturity ETF (DMF). Unlike traditional bond funds, DMFs target a maturity date (i.e. 2021) and hold their underlying bonds until they mature. On the target maturity date, DMFs will then distribute the matured bond proceeds to their shareholders. The objective of a DMF is to provide shareholders with the best of ETF and traditional bonds: a known maturity date, return of principal associated with traditional bonds, and the diversification benefits associated with ETFs and mutual funds.

DMFs’ unique features make them an effective way to lessen the risks that traditional bond ETFs face in a rising interest rate environment because:

1. They have a fixed maturity date; investors have less reason to worry regarding safety of their investment.
2. Less worry means DMFs are less vulnerable to panic-driven selling should bond prices fall.
3. They hold onto the bonds they own until their maturity and so they are less impacted by declining bond liquidity.

In my view, trying to predict what the bond market will do in the days and weeks ahead is a fool’s errand. After all, the financial media has continued to forecast the U.S. bond market as the next great asset bubble since 2013. Nonetheless, given the recent bond-market rally and the incredibly low rates on bonds generally, the time may be right to hedge against the risk that rising rates pose to traditional bond ETFs. DMFs could be an easy and cost-effective way to do so.