EC No, Bonds Aren’t Overvalued. They’re A Warning Sign

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There has been much commentary suggesting bonds have gotten overvalued due to historically low rates.

“Stocks are expensive, but bonds are enormously overvalued on a long-term basis” – Jeremy Siegel

However, is that the case?

There is no argument stocks are highly overvalued. We spent much of the past week discussing why forward returns will be lower over the next decade.

The basic premise is that overpaying for earnings today leads to lower rates of return in the future. Of course, given the flood of liquidity from global Central Banks, the overvaluation of markets is of no surprise.

However, while analysts develop various rationalizations to justify high valuations, none hold up under objective scrutiny. While Central Bank interventions boost asset prices in the short-term, there is an inherently negative impact on economic growth in the long term.

However, bonds are a different story.

Bonds Can’t Get Overvalued

Unlike stocks, bonds have a finite value. At maturity, the principal gets returned to the “lender” along with the final interest payment. Therefore, bond buyers are very aware of the price they pay today for the return they will get tomorrow. As opposed to an equity buyer taking on “investment risk,” a bond buyer is “loaning” money to another entity for a specific period. Therefore, the “interest rate” takes into account several substantial “risks:”

  • Default risk
  • Rate risk
  • Inflation risk
  • Opportunity risk
  • Economic growth risk

Since the future return of any bond, on the date of purchase, is calculable to the 1/100th of a cent, a bond buyer will not pay a price that yields a negative return in the future(This assumes a holding period until maturity. One might purchase a negative yield on a trading basis if expectations are benchmark rates will decline further.) 

As noted, since bonds are loans to borrowers, the interest rate of a bond is tied to the prevailing rate environment at the time of issuance. (For this discussion, we are using the 10-year Treasury rate often referred to as the “risk-free” rate.)

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