“Individual investors are fed up with the stock market,” writes TechTicker. “Burnt by 10 years of negative returns, two crashes, and a current economy mired with high unemployment and lackluster growth, many are throwing in the towel.”

Perhaps not surprisingly, retail investors have instead poured their funds into bonds in record numbers, helping to send yields to new lows.

Treasury yields are near record lows even while the fiscal position of the United States is the worst its been since the Great Depression–and arguably worse given the looming Social Security and Medicare solvency crises that will boil over with the retirement of the Baby Boomers.

It might seem almost silly to ask. But is there an irrational bubble in bonds?

The short answer, which will be controversial to many, is “no.”

This does not mean, of course, that bonds are an attractive investment at current prices. Unless you are an institutional investor whose investment mandate requires an allocation to longer-term bonds, yields are currently so low as to make Treasuries not worth owning.

But “unattractively priced” does not necessarily mean “bubble.”

This is not just a matter of semantics. There are some real differences here that do matter, and tossing the word “bubble” around indiscriminately can lead you to draw the wrong conclusions.

There is no precise definition of a speculative bubble, though Hyman Minsky gives us a good outline of what to look for. In Minsky’s model, a speculative mania tends to follow five stages, summarized below by Investopedia:

  1. Displacement: A displacement occurs when investors get enamored by a new paradigm, such as an innovative new technology or interest rates that are historically low.
  2. Boom: Prices rise slowly at first, following a displacement, but then gain momentum as more and more participants enter the market, setting the stage for the boom phase. During this phase, the asset in question attracts widespread media coverage. Fear of missing out on what could be an once-in-a-lifetime opportunity spurs more speculation, drawing an increasing number of participants into the fold.
  3. Euphoria: During this phase,caution is thrown to the wind, as asset prices skyrocket. The “greater fool” theory plays out everywhere. Valuations reach extreme levels during this phase. During the euphoric phase, new valuation measures and metrics are touted to justify the relentless rise in asset prices.
  4. Profit Taking: By this time, the smart money – heeding the warning signs – is generally selling out positions and taking profits. Note that it only takes a relatively minor event to prick a bubble, but once it is pricked, the bubble cannot “inflate” again.
  5. Panic: In the panic stage, asset prices reverse course and descend as rapidly as they had ascended. Investors and speculators, faced with margin calls and plunging values of their holdings, now want to liquidate them at any price. As supply overwhelms demand, asset prices slide sharply.

In looking at the Treasury market today, we cannot credibly say that we are following this model. Perhaps it could be argued that the housing and credit market collapse of 2007-2009 qualifies as a “displacement.” But what we are seeing in the market hardly qualifies as a “boom” and certainly doesn’t qualify as “euphoria.”

In judging the temperament of those currently buying Treasuries, it should be obvious that these are not greedy speculators chasing returns. They are shell-shocked investors who have lost their tolerance for risk taking.

No one likes Treasuries. No one is quitting their job to day-trade bonds like they did tech stocks in 1999. No one is taking out a liar loan to “flip” Treasuries like Miami condos in 2004.

It is an entirely different mentality. Retail investors buy them for the simple reason that they are not stocks.

Furthermore, in nearly all examples of bubbles–and in the recent housing and financial bubble in particular–leverage plays a major role in inflating prices. Miami condos would have never reached the absurd prices they did without the loose mortgage financing that was available. You could argue that the Fed’s loose policies are creating the leverage that is being used to buy Treasuries (thus keeping the prices high and the yields low), but this is not entirely accurate either. All else equal, loose monetary policy causes longer-term yields to rise, not fall. The Federal Reserve does not buy every bond put out by the Treasury and cannot mandate what market rates will be at all maturities of the yield curve. The Fed, though powerful, is not omnipotent. And total leverage in the U.S. financial system is continuing to shrink as the private sector deleverages faster than the Treasury can issue new debt (see Figures 1 and 2).

Figure 1: Total Debt Outstanding

Figure 2: Total Debt Outstanding–Federal vs. “Everything Else”

It would seem unlikely that we would have a bona fide “bubble” in anything during a period of financial system deleveraging.

So, while I have established that there is no “bubble,” per se, in Treasuries, I want to reiterate that this does not mean that the current price is attractive or that yields can continue to fall forever. At this point the potential upside to bonds is small while the potential downside is quite large.

Bonds, unlike stocks, commodities, or other assets, do have a theoretical maximum price. Except during a period of extreme volatility, yields can never fall below zero. In a world in which discount rates across all maturities fell to zero, the theoretical value of a bond would be its face value plus the cash value of any unpaid coupon payments. We’re not to that level of pricing yet, and it would be highly unlikely that we will ever get there. But as Japan’s experience in the 1990s and 2000s proved, yields can stay lower than anyone thinks possible for longer than anyone thinks possible.

I’ll wrap this up with some fairly straightforward trading advice. Given their current yields, Treasuries are not attractive as a “buy” right now. But given the deflationary forces still plaguing the economy, I wouldn’t be shorting them either. It might be best to simply avoid them altogether.

Charles Lewis Sizemore, CFA

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