Jeremy Siegel, Wharton professor and author of well-known Stocks For The Long Run, published an article this week in the Wall St. Journal saying that we are in a bond bubble. Bubbles are periods of irrational price appreciation in an asset class, followed by a return to rationality when everyone heads for the door and sells. With yields from government bonds at multi-decade lows, this is hardly a risky call.
Warren Buffett talked about a bubble in government bonds in February of 2009–well ahead of the curve:
‘When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s,’ he went on. ‘But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.’
Since Buffett made this call, government bonds have done okay. The iShares long government bond fund TLT, for example, has generated a total return of 10.5% over the year through July 2010 vs. 13.8% for the S&P500 index fund, IVV. This does not mean that Buffett was wrong—just that the run in government bonds has persisted. Buffett is a long-term investor, so a year’s time is not going to be a concern.
The bottom line with respect to government bonds is that the flows of money into these bonds may be (1) just a bubble, with people chasing performance, (2) a reflection of a belief in the risk of a double-dip recession, or (3) extreme levels of risk aversion. History suggests that investors tend to chase performance, so there is certainly some component of that in the run-up in bond prices, which corresponds to a decline in yield. On the other hand, there are other asset classes that have done very well in the last 1-3 years, so pure performance chasers would tend to look elsewhere. Gold is a notable example.
I tend to think that extreme risk aversion is the dominant factor in the large amount of money flowing into government bonds. The market reflected a very high tolerance for risk back in 2007, but investors appear to be highly risk averse today. The VIX, often referred to as the fear index, was at around 10 at the start of 2007 and now is at about 26. VIX reflects the cost of buying protection to hedge the downside risk of an investment in the S&P500. High VIX means that more people wish to buy this protection, so the price has gone up. This, in turn, reflects risk aversion.
So, what does all this mean? It is certainly true that yields on government bonds are really low on an historical basis. As such, we can expect prices to drop and yields to rise. The question is when. I have no crystal ball and neither does Mr. Siegel. As always, I worry that too many investors get caught in the prognostication trap rather than focusing on low cost and good diversification.
Photo: Phillip Capper