Everybody's looking for the next bubble, and they think bonds are it.
But that doesn't have to mean, as the BBC's Duncan Weldon worries, that bonds are a bubble. It could just be a boom that's justified by the fundamentals. No less an expert than Nobel-prize winner Robert Shiller, who called the tech and housing bubbles, thinks that bond prices make sense—and if anything, are too low—considering how far inflation and short-term interest rates have fallen. That, after all, has been the point of everything the Federal Reserve has done. Not only has it cut short-term interest rates to zero, but it's promised to keep them there, and bought enough long-term bonds that their prices have increased because there's less supply of them for everyone else. The result hasn't just been record-high prices for super-safe government bonds, but for less safe corporate bonds, too. That's because the Fed's bond-buying has forced people who had owned government bonds to do something else with their money instead—usually pouring it into riskier bonds. So if there is a bond bubble, it's, as Weldon puts it, a "policy driven" one.
A bubble isn't a bubble, though, unless it bursts. The question, then, is why this would happen or even look like for bonds. Now let's back up a minute. A bond is just a claim on a future stream of income. So the price of a bond is how much someone is willing to pay for that future stream of income today. But the important thing to remember is that the payments you get back don't change no matter what you pay for the bond itself. That's why higher bond prices mean lower interest rates: the more you pay, the smaller the payments you get are as a percentage of that. Why does this matter? Well, when people talk about a "bond bubble," they aren't talking about companies or countries defaulting on their payments, but rather the price investors are willing to pay for them going down when the Fed raises rates. But that means, as Brad DeLong points out, that you aren't going to get wiped out if bonds do crash. As long as you can afford to hold on to your bonds, you'll keep getting paid back as much as you were before. You just won't be able to sell them for as much as you used to. That's a lot different from, say, the housing bubble when mortgage bonds really did go to zero. These would only be paper losses that, if history is any guide, Shiller says would in the absolute worst case be around 12.5 percent.
Now paper losses aren't as bad as actual ones, but they can still be more than enough of a problem. The nightmare scenario goes something like this. The Fed raises rates and that makes the dollar go up so much that investors worry the foreign companies they lent dollars to won't be able to pay them back now. Everyone tries to sell their emerging market corporate bonds at once, and there are basically no buyers. So bond prices don't just fall; they free fall. And that could be even worse than it sounds, since a couple big players dominate the bond market. If one of them had bad enough mark-to-market losses—especially with borrowed money—then problems could spread to other markets. That's not very likely, but we can't rule it out.
Well, not entirely. We nearly can, though, because all of this depends on the Fed raising rates more than markets expect. It's only then that bond investors would panic and rush for the exits. But as long as any rate hikes are clearly telegraphed, any market fall out shouldn't turn into a freak out. That's why this "bond bubble" shouldn't be much of one. This Fed prizes transparency so much that it's hard to imagine it doing anything other than making its intentions well known ahead of time. So bond investors should yes, have some losses, but not a loss of confidence, when the Fed does eventually tighten policy. In other words, their bonds won't be worth as much on paper, but will still pay them as much as they always have.
If that's a bubble, that's a bubble we can live with.