Former Federal Reserve Chairman Alan Greenspan recently told Bloomberg that we are entering a bond market bubble in the U.S., and all signs point to yes. In fact, I would add that what was once a safe, stable and predictable investment class is about to be turned on its head, as interest rates rise and values plummet.
Even so, a bond-market bubble is different than a bubble in the stock market or real estate market. These are markets that bubble when the price paid for an investment cannot be justified by the profit the investor will gain. If the purchase price of a condo far exceeds what the investor can charge in rent, real estate prices become unsustainable (as we saw in 2007). If a company’s stock is trading at such a high price that the company can’t realistically generate a return on those investments, stock prices similarly have nowhere to go but down.
During the tech bubble of 2000, investors mistakenly believed that tech stocks were somehow different than any other investments and that profits weren’t needed for stock prices to rise. The market eventually market realized this, leading to the historic 78 percent decline of the NASDAQ composite. All in all, the common denominator in stock, real estate and bond market bubbles is this: Everyone is rushing to the fire exit, but they cannot get out in time.
Ultimately, bond investors face the same result if they do not rethink their strategies now. Interest rates are set to rise again. While holding long duration bonds has long been considered a safe investment strategy, that is no longer the case. The tried-and-true vanilla income strategy of the past is no longer smart or safe. The longer the duration of a bond portfolio, the higher the interest rate risk. Incremental rate increases could exponentially amplify the holder’s loss in purchasing power.
So, what should a conservative investor do going forward? The safest way for investors to minimize the risk that rising interest rates pose to bond prices is to add alternative forms of income to a short-duration bond portfolio. Here are examples of alternative vehicles to replace traditional bonds:
Reinsurance: A growing investment trend, reinsurance is the opportunity for investors to take on some of the risk and reward of catastrophe insurance. The risk lies in the event of a catastrophic event that requires a pay out to the insured, and the reward lies in sharing a portion of the premium if no such event occurs. If underwriters do their job and the insurance is priced right, investors make money with limited downside risk.
Alternative lending: Alternative lending is an investment in consumer loans ranging from small business loans to individuals requiring short term credit. In the past, banks were the primary lenders for these types of loans but since 2008, they have ceased the practice and peer lending companies emerged — shepherding in alternative lending funds. Although these loans may have a higher default rate, the higher yield negates some of the risk, and makes them much more lucrative than traditional corporate bonds.
Short-term, high-yield bond funds: Short-term bonds usually present a higher risk, given the low credit quality, but the short duration reduces the risk of default. This also allows the investor to move from vehicle to vehicle more quickly and capture the benefit of an interest rate increase.
Floating rate bonds: With shorter durations, the floating rate protects investors from the risk of locking into an interest rate now and regretting it when the Fed raises rates again.
International bonds: While the Fed may be raising interest rates at home, that doesn’t affect bonds outside the U.S. Right now, there are some emerging markets that are performing especially well.
All things considered, this is a first. Never have these factors converged at once: historically low interest rates set to rise, coupled with a population of investors holding such a large percentage of their portfolio in bonds. For portfolios that don’t diversify, we can easily guess the outcome. This is not meant to generate fear but to motivate investors to act before it is too late. Fortunately, there are alternative options that can provide security, stability and yield.
Jay Schechter is a partner at Singer Xenos Schechter Sosler Wealth Management, based in Coral Gables.
▪ This opinion piece, contributed to Business Monday in the Miami Herald, does not necessarily reflect the view of the newspaper.
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