Economic And Behavioral Factors Argue
for Persistent Bond Demand Over Time
Chief Investment Officer Fixed Income
Sponsored Content American Century Investments
October 19, 2010
G. David MacEwen
Chief Investment Officer
Fixed Income
In this paper, we consider the argument that there is a bond “bubble” in the context of current economic and market conditions. We examine academic literature for commonly accepted characteristics of speculative bubbles, finding little evidence to support the notion that the bond market is currently experiencing a “bubble.” Nor do we believe the term “bubble”—as it is often associated with short, sharp price changes in more volatile stock and commodity markets—accurately reflects the current reality of bond investing. In making this assertion, we reference our own proprietary analysis as well as recent academic studies of investor behavior.
While it is certainly possible that interest rates could rise over time, resulting in short-term losses for bond investors, our analysis indicates that fears of a bond “bubble” are overstated. The case for a bond “bubble” rests on the assumption that the market faces a sea change in interest rates, with investors abandoning bonds for stocks and other assets. On the contrary, we find that the economic conditions necessary to spark a bond market selloff (inflationary conditions or a pre-emptive Federal Reserve rate hike) are lacking in today’s environment of stagnant growth, modest inflation, and low interest rates. We also believe that demand for bonds should persist given the effects on investor risk appetites following a prolonged period of poor equity returns.
Finally, we look at the portfolio management implications of prevailing economic and market conditions for fixed-income investors. We argue that a sophisticated, multi-faceted approach, using strategies designed to maximize risk-adjusted performance over time, is best suited to the current environment. Indeed, an approach that attempts to minimize risk and maximize yield and return potential should be a central tenet of all bond investing, regardless of one’s position on the bond “bubble” debate.
The case for a bond “bubble”
Record-low interest rates and unprecedented demand for bonds, combined with outperformance relative to stocks for an extended period, have led some pundits to suggest bonds might be experiencing a “bubble,” with prices vulnerable to sharp declines.
Bond “bubble” advocates base their argument on a number of points. They say that fixed-income performance has been buoyed by a series of what they deem unsustainable supports for bond prices— low inflation and a policy of historically low short-term interest rates by the Federal Reserve (Fed). Those in the bond “bubble” camp argue that as inflation pressures increase (as economic conditions improve and/or
in response to the unprecedented amounts of fiscal and monetary stimulus provided to ward off a global depression as the Credit Crisis and Great Recession unfolded), the Fed’s short-term rate target and Treasury yields will shift dramatically higher from current levels, putting price pressure on the entire bond market.
Furthermore, bond “bubble” proponents note that net inflows to bond mutual funds reached a record high in 2009, and remained strong through the first half of 2010. Much of this buying is being driven by underperformance in other assets, particularly stocks and real estate. Indeed, bonds outperformed stocks during the “Lost Decade” of the 2000s, which many analysts suggest is a sign of an impending reversal.
Following this logic, bond “bubble” advocates argue that a sustained recovery by stocks would likely result in a sharp bond selloff as investors shift back to riskier equities. This argument fundamentally sees stocks and bonds as competing, rather than complementary, assets.
Why “bond” and “bubble” do not belong in the same sentence
Bubbles are typically associated with the following characteristics: sharp, short-term price increases followed by dramatic losses; the use of leverage to fuel speculation; euphoria about the asset; a focus on price gains rather than income payouts; and a short-term holding period. These are all at odds with the traditional rationale for bond investing, which emphasizes relative price stability, income generation, and typically long-term holding periods.
Extensive academic research on speculative bubbles is available, with contributions from such widely divergent fields as economic history and behavioral finance on the one hand, to mathematics and physics on the other. A survey of this literature yields several common characteristics associated with market bubbles.
These include the use of leverage; euphoria (or at least broad optimism) about the asset in question; a focus on short-term price gains rather than a long-term, dividend-based approach; and a technological or other exogenous catalyst for growth, among other factors. Perhaps most important, these bubbles tend to display significant short-term price increases above fundamental value driven by excessive speculation, followed by precipitous price declines, often resulting in losses that can take many years to recoup. The literature naturally tends to focus on bubbles in stocks, tulips and other commodities, as well as real estate.
Here we note one important similarity between Internet stocks and Dutch tulip bulbs in bubble literature— neither one writes you a dividend check. Indeed, in classic asset bubbles, investors do not seek income, but are almost exclusively focused on capitalizing on short-term price gains. These factors are in direct conflict with typical investor rationale for bond investing. In fact, we’d argue that a key reason why investors are buying bonds now is because they don’t want the price volatility of stocks. Also, the strong inherent demand for income from bonds appears to preclude the type of short-term holding behavior that is characteristic of bubbles.
Holding period and income are key to dampening bond price volatility
Bond total returns over time are supported by contributions from yield, significantly reducing the effect of short-term price declines. By comparison, stock and commodity bubbles can result in stunning losses. Holding period is also key in bond investing because, barring a default, fixed-income investors know with certainty that they will receive par value at maturity.
Even under extreme economic and interest-rate scenarios, bond price changes tend to be less dramatic than those experienced by stocks. This is because bonds are interest-bearing assets, with a stated maturity date, issued by such high-quality borrowers as governments and agencies, or backed by a collection of financial assets, such as mortgages or credit card payments. In the case of corporate bonds, these securities have a higher claim than equities on the issuing firm’s assets and typically have sizable recovery values in the event of bankruptcy or default. Of course, bond mutual funds are marked to market each day and do not mature, though a fixed-income fund’s underlying bond holdings do.
To demonstrate bond price volatility over time and how fixed-income investments compare with other asset classes after a severe price decline, we examine the hypothetical behavior of American Century® Diversified Bond under three different interest rate assumptions. Figure 1 below shows the hypothetical 10-year cumulative performance of Diversified Bond after instantaneous interest rate increases of 500 and 1000 basis points, compared with the actual returns of the Nasdaq Composite and S&P/Case-Shiller National Home Price indices since their respective peaks in 2000 and 2007. The “unchanged” line shows Diversified Bond’s hypothetical performance with no change in interest rates.
To be clear, the two rate-rise scenarios are radical in their severity, and are likely greater than any event that even the most strident bond bubble proponent could imagine. For context, consider that the worst year for bonds in the last two decades was 1994, when the Fed hiked its fed funds target rate 300 basis points in a series of moves from February 1994 to February 1995. (A similar increase in interest rates today would equate to an 8% loss for Diversified Bond.) Nevertheless, it is instructive to consider alternative return profiles for bonds in the event that we are wrong—despite the preponderance of the evidence—and the worst-case bond bubble scenario does indeed play out.
In the 500-basis-point-increase scenario, Diversified Bond would experience losses greater than 15% in year one; year-one losses would reach 30% in the 1000-basis-point-increase scenario. Fitting the extreme rate assumptions, such negative returns would unquestionably be severe in a bond context. Investors who bought bonds after fleeing losses in equities and seeking stability of principal would undoubtedly be bitterly disappointed. Worse, imagine investors capitulating and locking in losses after such performance.
This is precisely the point at which holding period becomes important. The income payouts of Diversified Bond’s underlying holdings begin to repay patient investors who hold the fund beyond year one. What’s more, when interest rates rise, the interest and principal payments on the portfolio’s underlying holdings can be reinvested at new, interest higher rates. As a result, based on our hypothetical results, investors break even in year three under the 500-basis-point scenario, and in year four under the 1000-basis-point scenario. In future years, the compounding effect of reinvested interest and principal payments results in significant positive total returns. The greater the rate increase, the greater the total return over time.
Compare those total return figures with performance of assets in other well-known speculative bubbles. An analysis of tulip bulb prices suggests truly remarkable price declines of 99% in the wake of the bubble. A more immediate example can be seen in the popping of the dot-com bubble—more than 10 years later, the Nasdaq Composite is still down almost 50% from its all-time high (including reinvested dividends).
Another important concept that cannot be emphasized enough with respect to the holding period for bonds: duration. A bond (or bond fund’s) duration is the measure investors should use when evaluating a fixed income investment for potential price volatility and length of time to recover possible losses. Duration is commonly defined as the weighted average time until bondholders are repaid; therefore, the greater a bond or bond fund’s duration, the greater its exposure to losses from rising interest rates, and the correspondingly longer holding period before breaking even. For example, as of August 31, 2010, Diversified Bond had a duration of approximately four years, while the American Century® Short Duration portfolio had a duration of about two years. Investors with a short time horizon or low risk tolerance would do well to favor fixed income funds or securities with comparatively short durations.
Economic and market factors argue against a bubble
We find virtually none of the economic or market conditions commonly associated with bubbles to be present in the fixed-income market.
Two important characteristics of bubbles are spikes in the use of leverage and in investor expectations that asset prices will continue to rise. Neither of these conditions pertains to the bond market at present. Focusing especially on the latter, investors are skeptical about bonds—the Sentix US Long Bond Sentiment Index is essentially neutral. This is a far cry from the positive readings recorded at the peak of the financial crisis, when investors were piling into Treasury bonds at an unprecedented pace. In addition, Figure 2 (on the following page) depicts net Treasury futures contracts, showing that the market is actually net short contracts, meaning investors expect Treasury yields to rise and prices to decline. This is hardly descriptive of the necessary conditions for a bubble in bonds or any other asset class.
For bonds to continue to rally, as in a speculative bubble, interest rates would have to move lower. But market consensus calls for higher, not lower, interest rates over time. What’s more, talk of hyperinflation and a “V-shaped” economic recovery has given way to a debate about whether the economy is entering another recession. Significantly, Fed policy-makers are openly discussing the likelihood of Japanese-style deflation in the U.S. and possible policy responses. Furthermore, any sharp economic recovery would require improvement in housing and employment, both of which remain weak. And, among financial markets, stocks remain very volatile, while the sovereign debt crisis, particularly in Europe, hangs over the entire financial system.
These conditions contrast markedly with an environment likely to promote higher interest rates. Indeed, as of this writing in early September 2010, the Fed has reiterated its commitment to hold interest rates at record lows for the foreseeable future. It is precisely these conditions of stagnant growth, modest inflation, and low interest rates that we believe investors should prepare for going forward.
Behavioral finance studies suggest steady, persistent demand for bonds over time, rather than a bubble
Recent academic studies suggest that stocks’ underperformance biases investors toward fixed-income products. This effect is particularly pronounced for younger, less experienced investors.
A recent research paper by National Bureau of Economic Research members Ulrike Malmendier of the University of California, Berkeley, and Stefan Nagel of Stanford University (Malmendier and Nagel; Depression Babies: Do Macroeconomic Experiences Affect Risk Taking?; May 2010) has important bearing on this topic. Malmendier and Nagel find that investor risk appetites are heavily influenced by past investment experiences. Specifically, their study covered the period from 1960 to 2007, and found that “individuals who have experienced low stock-market returns throughout their lives so far report lower willingness to take financial risk, are less likely to participate in the stock market, invest a lower fraction of their liquid assets in stocks if they participate, and are more pessimistic about future stock returns.”
As a result, investors are very risk averse coming out of this recent financial crisis—a long period of underperformance by stocks has colored investor choices in favor of fixed-income investments. This extended underperformance in absolute terms and relative to bonds could influence investor sentiment for years to come, just as investors heavily favored bonds over stocks in the wake of the Great Depression. The effect noted by Malmendier and Nagel is even more pronounced for relatively inexperienced
investors—young people appear to be more strongly influenced in their investment choices by recent losses. This has important implications for investors whose experience of the market has been defined by stocks’ “Lost Decade.” This creates an interesting and counterintuitive dichotomy where young people are more risk averse than you would otherwise expect, while older people who have experienced a sustained
stock bull market hold a more sanguine view of equities. This would argue for persistent demand for fixed-income products from even young investors.
Figure 3 below depicts the rolling four-year returns for the Ibbotson U.S. Intermediate-Term Government Bond Index going back more than 80 years. The graphic is important because it shows that intermediate term U.S. government bonds have not experienced negative returns for any four-year period going back to the Great Depression. This relatively pain-free profile, and its possible influence on investor behavior, suggests positive demand for bonds going forward.
More behavioral finance influence: Figure 4 (on the following page) shows the annual return ratio of bonds to stocks, overlaid with a ratio of net cash flows into bond and equity mutual funds. The chart demonstrates that when the return ratio exceeds 100% (where bonds outperform stocks), bond fund flows exceed those to stock funds, indicating an investor preference for bonds in these periods. The comparatively poor long-term performance of stocks suggests bonds will remain popular with investors beyond 2009-10.
Fixed-income solutions for a low interest-rate environment
Our analysis shows that a diversified “core-and-satellite” approach to investing within a bond allocation can provide greater yield and return potential with little or no increase in risk relative to core and short duration bond funds.
An environment of prolonged low economic growth and interest rates has important implications for how investors allocate their fixed-income assets. We believe successful investing—defined not simply in terms of achieving the highest possible absolute returns, but as meeting specific investor goals in a risk-adjusted framework—requires putting a structure in place to account for this new reality confronting financial markets.
Indeed, even though we cannot predict what the economy and markets will do, the prevailing economic and rate environment suggests modest investment returns going forward. If this is correct, investors should temper return expectations and focus instead on maximizing risk-adjusted performance. The best way we know to accomplish this objective is to spread investments across asset classes whose performance
varies for given stages of an economic and market cycle. This is the very definition of diversification.
This concept applies within, as well as across, asset classes. Equity investors are very familiar with the process of combining multiple investments across international and domestic markets, and along the capitalization and style spectrum. But this practice contrasts markedly with typical fixed-income investor behavior. Long experience in the fixed-income market tells us that even fairly sophisticated bond investors tend to hold a single bond product. This is typically a “core” or “diversified” bond portfolio managed against a broadly diversified fixed-income benchmark, such as the Barclays Capital U.S. Aggregate Index or Citigroup Broad Investment-Grade Bond Index.
We believe a more sophisticated “core-and-satellite” approach to bond investing is required to maximize risk-adjusted returns. Our analysis, conducted using American Century fixed-income portfolios, shows that it is possible to combine a suite of bond portfolios to generate solid risk-adjusted performance over time. In this context, it is worth remembering that assets do not have to be negatively correlated to provide diversification benefits; even positively correlated investments, such as different fixed-income investments, can enhance diversification.
Intermediate- and short-term optimized portfolios can provide greater yield and return potential than core and short-duration bond portfolios with similar risk
We found that an American Century Investments bond allocation that is approximately 47% weighted to Diversified Bond, 19% to High-Yield, 16% to Ginnie Mae, 11% Short Duration, 5% International Bond, and 1% Inflation-Adjusted Bond has a lower standard deviation and higher expected return than Diversified Bond alone. Significantly, such a combination offers more yield but with less interest rate risk (duration would be 3.76 years for the combined portfolio versus 4.40 years for Diversified Bond).
More cautious investors concerned with limiting price volatility but increasing yield over money market investments are likely to concentrate on the short end of the yield curve. We found that a similarly diversified approach among short-term securities can deliver greater yield and return potential with only a fractional increase in risk.
An American Century Investments bond allocation that is approximately 63% weighted to Short Duration, 17% cash, 10% High-Yield, 5% Ginnie Mae, 3% Diversified Bond, and 1% International Bond provides more yield than Short Duration alone, with a nearly identical standard deviation of returns over time and only fractionally higher interest rate risk.
The composition and risk characteristics of these hypothetical portfolios can be seen in Figure 5 below.
| Figure 5: Hypothetical "Core-and-Satellite" Portfolios | ||
| 2% Standard Deviation Portfolio | 4% Standard Deviation Portfolio | |
| Fund or Securities Components | Component Weighting | Component Weighting |
| Diversified Bond ("Core" for 4% Portfolio) | 2.79% | 47.33% |
| Short Duration ("Core" for 2% Portfolio) | 62.73% | 11.00% |
| Ginnie Mae | 5.26% | 16.19% |
| High-Yield | 10.29% | 19.00% |
| International Bond | 1.41% | 5.13% |
| Inflation-Adjusted Bond | 0.36% | 1.21% |
| T-Bills | 17.16% | 0.14% |
| Hypothetical Portfolio Duration | 1.94 years | 3.76 years |
| Hypothetical 30-Day SEC Yield | 2.04% | 3.71% |
This hypothetical information is for illustrative purposes only and is not intended to represent any particular investment property. Source: American Century Investments proprietary analuysis |
||
These allocation examples are particularly timely because diversified and short duration bond funds are the two fastest-growing fixed-income market segments. In a period of heightened uncertainty and likely low absolute returns, maximizing risk-adjusted returns is crucial to investment success over time. We believe applying this “core-and-satellite” approach is an important potential opportunity to add value to investor portfolios.
Conclusion
Despite considerable discussion in the financial media about the existence of a bond market “bubble,” we find little evidence to support this claim. None of the factors traditionally associated with asset bubbles are at work in the bond market at present. Bond bubble proponents base their argument largely on record flows into fixed-income investments, bonds’ outperformance over stocks, and record low interest rates. However, we believe that the confluence of a number of important factors argues for a prolonged period of low interest rates and modest inflation. In addition, the bond bubble camp assumes that investors view stocks and bonds as oppositional, rather than complementary, assets, a thesis we reject.
The nature of bonds themselves also argues against the sharp price swings and breathtaking losses typically associated with the aftermath of asset bubbles. The holding period of a bond investment is also key—the price at maturity is known, and the longer an investor holds a bond, the greater the cumulative contribution to return from income payouts. While bond mutual funds do not mature, they are composed of assets that do, and also offer a greater likelihood of recovery of losses resulting from rising interest rates the longer the holding period. As a result, the only way fixed-income investors can realize bubble-like losses is to sell their bond holdings immediately after rates increase, locking in losses, and not allowing the compounding effect of regular interest payments to work over time.
This is not to diminish the anxiety investors would likely feel if the most extreme economic and interest rate scenarios became a reality. Nevertheless, we believe we have demonstrated conclusively that current economic and market conditions make these sorts of outcomes extremely unlikely at present, and that even under the most dire return assumptions, investors with intermediate- to long-term holding periods will realize significant positive returns over time as interest and principal payments are reinvested at new, higher rates.
Finally, we believe that financial conditions argue for generally heightened volatility and relatively modest investment returns going forward. As a result, we think investors will be best served by a focus on maximizing risk-adjusted performance as opposed to absolute returns. Not only is this true across asset classes, but also within them. Specifically, we advocate for a sophisticated “core-and-satellite” approach to bond investing. Our research demonstrates that holding an optimized mix of fixed-income investments can provide greater yield and return potential with little or no increase in risk over a typical core or short duration bond position.
The Nasdaq Composite Index is a market value-weighted index of all domestic and international common stocks listed on the Nasdaq stock market.
The S&P/Case-Shiller U.S. National Home Price Index tracks the value of single-family housing within the United States. The index is a composite of single-family home price indices for the nine U.S. Census divisions and is calculated quarterly.
The Sentix US Long Bond Sentiment Index is based on monthly opinion polls of investors about the U.S. bond market. Index values are calculated monthly by taking the number of bullish bond votes minus the number of bearish bond votes and dividing the difference by the total votes. A zero value indicates a neutral opinion.
The Ibbotson U.S. Intermediate-Term Government Bond Index is a market-value-weighted custom index designed to measure the performance of U.S. government bonds.
The Barclays Capital U.S. Aggregate Bond Index represents securities that are taxable, registered with the Securities and Exchange Commission, and U.S. dollar-denominated. The index covers the U.S. investment-grade fixed-rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.
The Citigroup US Broad Investment-Grade (BIG) Bond Index is a market-capitalization-weighted index that includes fixed-rate Treasury, government-sponsored, mortgage, asset-backed, and investment-grade issues with a maturity of one year or longer.
A Natural Logarithmic Scale is used in Figure 4 on page 7 to keep the bond/stock flow data constrained within the boundaries of the graph. A logarithm is the power (exponent) to which a base number must be raised to get the original number. Any given number can be expressed as y to the x power in an infinite number of ways. Base 10 is commonly used. Another common option is the Natural Logarithm, where the constant e (2.7182818) is the base. The right-side y-axis in Figure 4 shows the exponent to which e must be raised to get the data number.
Generally, as interest rates rise, the value of the securities held in the fund will decline. The opposite is true when interest rates decline. The lower rated securities in which the High-Yield Fund invests are subject to greater credit risk, default risk and liquidity risk.
The prospectus contains very important information about the characteristics of the underlying security and potential tax implications of owning the Inflation-Adjusted Bond Fund. International investing involves special risks, such as political instability and currency fluctuations. Investment return and principal value will fluctuate and it is possible to lose money by investing.
The opinions expressed are those of the investment managers and are no guarantee of the future performance of any American Century portfolio. Statements represent personal views and compensation has not been received in connection with such views. This information is not intended to serve as investment advice.
You should consider the fund’s investment objectives, risks, and charges and expenses carefully before you invest. The fund’s prospectus or summary prospectus, which can be obtained by calling 1-800-345-6488, contains this and other information about the fund, and should be read carefully before investing.
For more information, contact your financial professional.
American Century Investment Services, Inc., Distributor
©2010 American Century Proprietary Holdings, Inc. All rights reserved.
IN-WHP-69479 1009
Non-FDIC Insured • May Lose Value • No Bank Guarantee
Display article as PDF for printing.
Would you like to send this article to a friend?
Remember, if you have a question or comment, send it to .
