In my last post, I described what I believe is the largest bubble ($95 trillion in size) of our lifetime: the debt bubble. Since then, as expected, I’ve received feedback on how I may be wrong about my bubble thesis. I certainly could be wrong, but I certainly don’t think I am.
I got the same reaction when in 2007 I wrote in local papers that I thought the stock market was overvalued and investors ages 50+ should start taking money out of the market and locking in their gains. But it’s safe to say that I am not without my critics. The following are the most commonly expressed criticisms and objections to what I think is the next BIG bubble. My desire is to arm you with some facts:
“Interest rates won’t rise anytime soon.” Maybe. The Federal Reserve has stated that it plans to keep (manipulate) rates low in the short term. Honestly, can you trust anything that comes out of Washington? Furthermore, interest rates can rise due to poor bond auctions like they did in Spain, Greece, Italy, Ireland, and Portugal because of a lack of trust in those governments. Sound familiar? I still wonder with rates so low and bond prices so high why anyone would want to be holding bonds right now anyhow.
“When interest rates rise, we will get out of bonds.” Timing is everything. The question is: Can you or anyone time this, or are you playing with fire? Not to step on toes, but what was your experience with timing the market in 2008? I can tell you from experience that no one can time any market. I was good (and somewhat lucky) in 2007 to encourage local investors to go safe near the all-time high of the market. Know your limits and you will be truly wise.
“Rising interest rates will only affect long-term bonds.” Long-term bonds are certainly the riskiest bonds, but short and intermediate length maturities are certainly not immune from rising interest rates. Many remember October 19, 1987, as “Black Monday” because of how much they lost in the stock market, but many are surprised to learn that far more wealth in terms of dollar value was lost in bonds on “Black Monday” than in stocks. Why? Because interest rates rose from 7.29 percent to 10.25 percent, causing bond prices of varying maturities to plunge just like a seesaw.
“Own bond funds because they’re professionally managed.” Bond funds are inferior to owning individual bonds because you have zero control from the get go; you’re at the mercy of the fund manager to navigate a bond portfolio that will lose ground rapidly when rates rise. Understand that the mandate of fixed-income funds is to be invested in bonds, not to sell and hold cash. I don’t think bond fund managers will be able to avoid this bubble just like virtually all stock fund managers were unable to avoid the crash of 2008.
Beyond interest rate risk, which is certainly the most deadly risk to bond owners, there are seven other risks you need to know about.
Default risk: When the bond issuer fails to make interest payments because of bankruptcy, etc.
Prepayment risk: When the bond issuer “calls” the bond back before maturity, forcing you to find a new home for your money.
Reinvestment risk: When the funds from a “called” bond are reinvested at a lower yield.
Market risk: When an overall market decline affects individual bonds with otherwise strong fundamentals.
Stock market risk: When stock market declines and redemptions affect bond funds because of their correlation to the stock market.
Liquidity risk: When you sell a bond at a loss because the bond issue is meeting weak demand.
Inflation risk: When higher than expected future inflation erodes the value of principal and interest payments.
Robert Russell is CEO & CIO of the Ohio-based Russell & Company, a private wealth management firm specializing in helping affluent individuals ages 45 and up create and preserve their wealth. He co-hosts a radio show, authors The Rob Report blog, and is a frequent contributor to FOX Business and CNBC.
Securities offered through Kalos Capital, Inc., Member FINRA, SIPC. Investment Advisory Services offered through Kalos Management, Inc., 3780 Mansell Rd. Suite 150, Alpharetta, GA 30022, (678) 356-1100. Russell & Company is not an affiliate or subsidiary of Kalos Capital, Inc. or Kalos Management, Inc.