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How Big a Bond Bubble?

Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

Investors have been gravitating to bond funds over the past few years, but will that turn out to be a bad bet to have made?

Here to discuss that question is Fran Kinniry. He is principal at Vanguard's Investment Strategy Group.

Fran, thanks for being here.

Fran Kinniry: Thank you, Christine.

Benz: So, let's talk about this bond bubble idea we've seen percolating. Do you think that we're in the midst of a bond bubble currently?

Kinniry: Well, we try to educate on some of the materials we have recently put out. And first I want to define a bubble, the bubble of the stock market typically, you think about a decline of 20%, and same thing even with the real estate bubble that we just saw--significant decline.

So, while we think bonds may be a little bit ahead of themselves and current yields look quite low, a bubble of that magnitude is probably unlikely.

Benz: Okay. So, when you think about the sorts of declines that investors might expect to see in bonds in a sustained period of rising interest rates, can you help put that in context, what might investors expect in the decades ahead?

Kinniry: Sure. I think most people are not used to having a negative return in bonds. And that certainly is a possibility if not a probability at some point in the future when interest rates rise. But if you're broadly diversified and have an intermediate duration, which is a core bond holding, then the order of magnitude of losses have, in the past, come inside of negative 10%, and so something around that should not be ruled out and something even worse. But to think of bubbles that have occurred in other asset classes, we would not expect to see that kind of magnitude of losses.

Benz: Okay. So, one thing I've been hearing from our users is, why not just shorten up? If we are all thinking that rates are going to go up in the next several years, why not just move into short duration securities, bond securities, and call it a day? What do you say about that strategy?

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Kinniry: Well, two things I would say. First, I was doing a lot of interviews with the financial press back in 2001, and everyone thought interest rates had to rise then. And so we've been talking about interest rates having to go up, really for the last 11-plus years. So, I would say it's very difficult to forecast interest rates, number one.

Number two, the yield curve today, which means the compensation you get from going from short to intermediate, is quite steep. Meaning that the penalty or the opportunity lost, if you were to go from intermediate bonds to short, or to money markets, you're really giving up a lot of yield.

So, we really think investors should really focus on bonds as a diversifier to equities, and bonds as a longer-term investment, not trying to get too tactical, because predicting interest rates is quite difficult.

Benz: So, at the other end of the spectrum I hear from users who say, "well, dividend-paying stocks appear to represent a pretty attractive alternative to fixed income at this point." What's your thinking on that approach?

Kinniry: We would argue that the whole stock market in general looks quite appealing today, especially relative to bonds. So, Vanguard's forecast on the equity market is for normal-like returns of 8% to 10%. However, we actually think that the equity risk premium--so, equities to bonds and equities to money markets--looks attractive. So, we are certainly in the camp of saying, make sure that you have equities, especially for the long run.

We don't necessarily believe in overweighting dividend-paying stocks. I think one of the things that most people forget is that stocks and mutual funds that have stocks that pay dividends, they go ex-dividend. So, the stock price of the mutual fund drops by the same amount as if whether a dividend is paid or not. So, accelerating or trying to increase your dividends, probably not the best approach, but certainly thinking about equities as a total return vehicle to a balanced portfolio.

Benz: So, so far we've talked about the bond market is kind of a monolith, but obviously there are lots of different pockets and very different behaviors within the fixed-income sector. Are there any areas that you view as containing more risk than others right now, any areas that appear more or less attractive to you?

Kinniry: In the bond market you're saying?

Benz: Yes.

Kinniry: The thing that's interesting to us is we've seen the high-yield market and the corporate market come all the way back to pre-Lehman levels, and yet the stock market is still off 25%.

So we're not saying that ... usually those things, one of those things is pricing the marketing incorrectly – so certainly we think that the corporate trade or the high-yield trade that when spreads were really wide at the height of the contagion, that has really worked itself out.

And certainly so, again our appeal will be back to the equity market for riskier investments rather than trying to gravitate towards longer duration or gravitate towards lower credit quality, we would say that investors would be probably better off taking a small portion of their portfolio and leaning towards the equity market.

Benz: Okay, well thank you Fran, helpful insights. We appreciate you being here.

Kinniry: Thank you very much, Christine.

Benz: Thanks for watching. I'm Christine Benz from Morningstar.com.