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Is there a Bond Bubble that is about to Burst?

We have been repeatedly asked over the course of the last several weeks if there is in fact a bond (or more specifically a U.S. Treasury bond) bubble that is about to burst.  A valid argument can be made for the likelihood of a drop in U.S. Treasury bond prices in the near future due to the following factors:

1)  A reversal of the “flight to quality/safety” trade that accelerated in the 4th quarter of 2008 and into the first quarter of 2009 where investors left the volatile equity markets in droves seeking the comfort and perceived safety of U.S. Treasuries.  This reversal has likely taken place as a result of the recent ascent of the stock market. The chart below showing the performance comparison of the iShares Barclays 20+ Year Treasury Bond ETF (TLT) vs. the S&P 500 Index (^GSPC) for the prior six month period as of August 5, 2009 seems to show the shifting investor sentiment away from Long-term Treasury Bonds to Equities starting in the middle of April 2009.  This is interesting as we believe that March 9, 2009 will mark the bottom of this particular bear market.

2)  With the Federal Funds rate at a range of 0.00% – 0.25%, the only potential direction for interest rates is higher.  As the threat of inflation increases and the belief that the U.S. recession may end later this year, the likelihood of interest rate increases by the Federal Reserve also increase (although we do not believe that this will happen anytime soon).  As interest rates rise, bond prices generally fall.

 

 

3)   Over-supply of U.S. Treasuries to support the on-going economic stimulus measures of the Federal Government and the potential for weakened demand for U.S. Treasuries by large institutional buyers such as China.  As with other securities, as supply increases and demand falls, prices generally fall as well.

 

However, looking at this question from an individual investor perspective, one should first consider the goals and objectives of an investor when purchasing bonds.   Are they using bonds as a trading vehicle to try and achieve growth over the short-term or are they using bonds to achieve a predictable stream of income and principal protection when held to maturity?  If the former is the case, this type of investor should likely consider reducing their allocations to bonds due to the aforementioned reasons.  If the latter is the case, this type of investor should not be overly concerned as they will still receive the same streams of income that they are currently accustomed to and should still expect to have their principal returned to them when the bonds mature.  

The author of this article is an employee of Hennion & Walsh, Inc., a brokerage firm specializing in tax free municipal bonds. The content of this post is not to be viewed as a recommendation.

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