Billions have been poured into bond funds in the last couple years, so with these large amounts of investments, it’s pretty clear why people worry about a bond bubble.
- People burnt in stocks during the credit crisis, so they are looking for safer havens
- CD bank yields are incredibly low, so people are looking for more yield
What to look for towards the end of the bond bubble
Interest rates will start creeping up. This will cause bond mutual fund net asset values to start decreasing. Problems occur when people start taking money out of bond mutual funds. If many people do this at the same time, the net asset value of these bond mutual funds will fall even faster. At that time as interest rates rise, money market mutual funds should start to yield more, and people will slowly move their money into these safer funds.
If municipal bond problems arise, people might run for the exits all at once, causing municipal bond mutual funds to fall rapidly and possibly causing a macro, contagion-type risk. Hopefully defaults will remain few and far between, localizing the impacts.
Techniques to manage bonds
Set a mental note for a net asset value level below which, you will sell the fund. Say the mutual fund is currently selling at $11 a share, you select $10.50 as the level at which you will sell the fund. Bob Brinker has repeatedly suggested this technique on his radio program. We suggest you put it in writing so there is no question. How do you pick a price? One technique would be to look at your average cost per share and use that.
Another method to cushion bond volatility is to buy individual bonds, and hold them to maturity. Holding a bond will allow you to collect the full amount of its interest and capital and not be subject to that wild gyrations of the bond market.
Another technique to manage the possible bond bubble is to stick to short term and intermediate term bond mutual funds. These have shorter duration and shorter maturity bonds within them, so they should weather interest rate increases slightly better than longer-term mutual funds. Note that this is not as foolproof as one would think, as a recent Vanguard article talked about some of the fallacies.
Other bond mutual funds to look at to try to avoid future inflation glitches include TIPS mutual funds which invest in Treasury Inflation Protected securities and commodity funds which will rise in value as inflation hits.
In conclusion, whether we are or not in a bond bubble is a matter of academic argument. Investors need to understand what they own, what the risks are, and what to do if inflation starts to flare up. Investors need to take steps and put together a plan of action so they are ready if interest rates start to move up.
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