Former Federal Reserve Chairman Alan Greenspan has warned about a bubble in the bond market. (J. Scott Applewhite/AP Photo)

Former Federal Reserve Chairman Alan Greenspan — who once famously warned of “irrational exuberance” — appeared on CNBC this month and ominously warned that the bond market could collapse, bringing stocks down with it.

“The current level of interest rates is abnormally low and there’s only one direction in which they can go, and when they start they will be rather rapid,” the former Federal Reserve chief said.

Greenspan said the end of a prolonged bull market in fixed income is fast approaching as the Fed, under Janet Yellen, begins raising interest rates from their record lows.

Almost all of us who are approaching retirement age have some money, somewhere in the bond market — whether it’s mutual funds, ETFs or taxable savings.

The Post asked Rajeev Sharma, director of fixed income at Foresters Investment Management Company, to demystify the bond bubble and what might be behind Greenspan’s statements.

Q: Why is Alan Greenspan important? What impact does he have?

Alan Greenspan served as Fed chairman from 1987-2006.  Among other things, he is often credited with creating the dot-com bubble through easy-money polices and then bursting that bubble by raising interest rates several times in 2000.

After leaving the Fed, Greenspan formed an economic consulting firm, Greenspan Associates.  His views and forecasts remain relevant, especially during volatile times in the markets.  For example, Greenspan had forecasted a possible recession in the United States in early 2008.  The market reacted subsequently by dropping over 3 percent in one trading session.

 

Q: What is a bond bubble?

The term “bond bubble” has been in the news quite a bit lately. A bubble in any asset class occurs when investors continuously pay higher and higher prices to buy a specific asset. Valuations do not make sense, but demand continues.  This makes the price of that asset go higher and higher to the point where it seems unreasonable. We have seen this in the past with the dot-com bubble (2000-01) and the housing bubble (mid-2000s). This time the reference is bonds, and we have seen bond valuations steadily move higher since 2012. A bond bubble occurs when bonds (be it treasuries, investment grade corporate bonds, high-yield bonds, and/or emerging market bonds) trade at higher and higher prices for an extended period of time.

We have witnessed several years of outperformance for U.S. Treasuries, investment grade corporate bonds, high yield bonds, and emerging market bonds. The run-up in prices has a lot to do with strong investor demand and a sentiment that prices will continue to go higher, based more on technical analysis rather than fundamental analysis.  The outperformance over this extended period of time has led many in the financial community to proclaim that bonds are a bubble and are poised to burst. When a bubble bursts, prices eventually crash and then the market experiences a prolonged period of weakness in the specific asset class.

What else should I know?

Many investors have an allocation to bonds in their portfolios as a way of diversifying your portfolio. Bonds tend to be more stable and allow for steady income. However, if demand for bonds were to slow down (which has not happened for years), the bond bubble could burst. In the event of that an bond crash happens, prices would drop and the investor would suffer a loss.

When we speak of bonds, we often focus on U.S. Treasuries.  Treasuries have been known as the “baseline” of what your money can return with little to no risk. So an investor’s bond allocation in his/her portfolio could include treasuries securities. How do they work?  Every six months, treasury notes pay an amount equal to half of their “coupon rate.” Here’s an example: say you have a $10,000 invested in a ten-year treasury note with a coupon rate of 4.25 percent. Every six months, you will receive a payment of $217.50 from the government, then when the note matures, you can redeem it for $10,000. Thus, depending on market conditions, such bonds can sometimes sell below their face value and at other times above their face value. These treasury bonds are considered a part of any low-risk investment portfolio because of their stability. While stocks often outperform them, these treasury securities keep earning even when the stock market is down because of that coupon payment. So now if we are talking about the bond bubble, it is important to understand where Treasuries are trading. U.S. Treasuries are trading at very high prices currently as yields have fallen to lower levels since the start of the year.

Q:  What should I do about it?

It’s important to understand your exposures to the bond market.  A long-term investor should be prepared to invest through cycles of rich valuations (and potential bubbles) and continue to search for opportunities when they present themselves in the bond market.  Risk tolerance is key.  Bonds continue to offer diversity to an investment portfolio.

It is extremely difficult to successfully call the top of the market.  Many have tried and failed and ended up missing out on opportunities in the market.

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