Every day I turn on CNBC or listen to Bloomberg, I know one thing… I will hear someone talk about a “Bond Bubble.” They have been talking about it for years, but we have yet to see it. We know a bubble… just imagine blowing a bubble gum bubble, and then it pops all over your face! That’s similar to a financial bubble which is essentially when an investment type (think real estate, dot com, etc.) grows to be too large, and then pops and splatters all over our face creating a huge mess.
Before we can even worry about the Bond Bubble, though, we need to better understand bonds.
The bond market is quite interesting and doesn’t get the hype the stock market does, but it should. A quick fact many may not know, the bond market is actually bigger than the stock market!
Now to explain how bonds work, think back to when you have lent a buddy of yours $20 bucks. Because she is our friend, we trust she will pay it back. However, if we were to be formal, we could write up a document that she would sign saying she’ll pay us back with some interest. It’s similar to our mortgage, but we’re the bank. That document we have then created is a bond… an obligation by someone else to pay us back with interest.
Alright, so that simplified it. Now let’s talk a little about how bonds work within our investment portfolio.
Imagine a bond is a seesaw with the price of the bond on one side and the yield or interest rate the bond pays on the other. As one side goes up the other side goes down. For example, if the bond price goes up, the interest rate goes down and vice versa.
Now imagine that the seesaw is really long, and on each side of it, we have multiple bond prices and multiple interest rates. The swings in the seesaw (or the impact of motion) are typically smaller for the prices and interest rates closest to the middle of the seesaw (fulcrum), but those that are all the way on the ends will see huge swings.
That’s how you can think about the difference of the seesaw swing in prices and interest rates relative to the length of your bond. The longer the bond, like a loan you give to your friend for 10 days versus one you give to them for 10 years, the greater the impact of the seesaw.
Alright, last piece I think it is necessary for us to touch is that there are different types of bonds.
We have many different types of bonds… for instance, the risk associated with loaning Home Depot money is less than loaning money to the kid in your neighborhood trying to develop a new app.
Go back to that example of us loaning our friend money. If the friend that we are loaning money to is responsible, we know they have a good job, they tend to pay us back on time… then we will charge them a lower interest rate. Let’s call this person Jimmy B Good.
On the other side of this, if we have another friend who is a nomad, moves from place-to-place, can’t hold a steady job and continues to ask us for money, then he poses a higher risk, and we should probably charge him a higher interest rate. Let’s call this person Johnny B Bad.
Jimmy B Good vs Johnny B Bad is a similar battle that is experienced in the bond market. You have Jimmy B Good companies that are deemed by investment professionals to be “investment grade.” Then you have Johnny B Bad companies who are “high yield,” but they are riskier. Having a mix of both Jimmy B Goods and Johnny B Bads can be a positive as it adds diversification to the portfolio!
So, despite the recent headlines about rates rising and a possible bond bubble, it doesn’t necessarily impact all bonds equally. It impacts different bonds in different ways, typically based on the term of the bond or the type.
Now while that’s all great, your next question is probably, “Well, I have bonds in my portfolio, and they fell this week… what do I do? I don’t want to have this bubble pop on my face.
I would respond to this question with another question, “Why are you holding bonds?” I’m guessing your answer is likely, “To help keep my whole investment portfolio, which is made up of stocks and bonds, from falling when the stock market falls.”
This past week stocks didn’t fall, and thus the bonds did not see any action. However, we want to hold onto bonds for when the stock market does fall. That is diversification at its finest. Don’t buy into the hype of the headlines. Be sure to chat with one of our Wela advisors if you have any questions about how bonds function as part of an investment strategy.
This information is provided to you as a resource for informational purposes only. It is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal. This information is not intended to, and should not, form a primary basis for any investment decision that you may make. Always consult your own legal, tax or investment advisor before making any investment/tax/estate/financial planning considerations or decisions.