July 24, 2013

What Bubble Gum Can Teach Us About Bond Bubbles

I’ve always fancied myself somewhat of a bubble gum aficionado, and fondly remember my childhood when I pestered my mom for some Big League Chew in the grocery store checkout line. I got pretty good blowing the largest bubbles and keeping them from popping all over my face. As I recently reminisced about my bubble gum-blowing days, I noticed some interesting similarities between U.S. bond bubble metrics and those of different bubble gums. Let me explain their shared characteristics.

#1: Gum Flavors/Bond Types

I was never a huge fan of most bubble gum flavors other than basic grape or original, as the other flavors always tasted awful to me or didn’t keep their flavor long enough. The same holds true for bonds, as they come in all different types, such as government bonds, municipals, corporates, bank loans, mortgage-backed securities, agencies, etc., and everyone has their favorites.

Yet each of these bond types, while still being bonds, are not created equal. As a true gum fanatic, you don’t just buy bubble gum because it’s gum. You determine which flavor or chew ability best fits your current needs and desires, and then buy it for those reasons. It’s no different when managing your client’s portfolio in the current bond market. You need to structure the bond side in a manner that can fulfill the client’s goals and needs, based on the current bond environment, which may mean changing the types of bonds your clients prefer to own.

#2 Gum Duration/Bond Maturities

The main reason I’ve always liked grape and the original flavor of bubble gum is because their flavor actually lasts the longest compared to others. They also have better "chew ability," which improves the ability to blow big bubbles. Bonds are really no different when it comes to their maturities. The longer maturity bonds will most always pay a higher coupon than the intermediate or shorter maturity bonds. Therefore, more coupon is usually the default of what most people look for when allocating the bond side of a portfolio, but that simple approach may not always work. 

So you should always assess a client’s objectives against the current market situation. In other words, if I only have 30 minutes to chew a piece of gum, I don’t want to waste the best flavors or most chewable piece. Bonds are very similar in regard to our current interest rate situation. Why waste long maturity bond money on a bond currently paying lower than average coupons, if there’s the possibility that future bond issues will be paying somewhat higher coupons in four to five years? 

#3 Gum Bubble/Bond Bubble

As a kid, I spent hours teaching myself how to blow bubbles with my chewing gum. I got pretty good, but sometimes the BIG bubbles would burst all over my face, resulting in a sticky mess. 

During the next five to 10 or even 20 years, the forward-looking bond bubble will result in long-term interest rates going up; and when they rise, the prices of all bonds will be discounted. So, much like my bubble gum bubbles, how do you keep that bubble from bursting?  

In the current bond market, it’s best to stay with shorter to intermediate maturities, as that will help lessen the devaluation, especially if interest rates rise rapidly. That seems simple enough, right? It’s not, though, because shorter maturities usually have the lowest coupons/yield, just like those other gum flavors have the shortest period of flavor retention, resulting in less bond yield satisfaction for clients in the short term.  

To manage the interest rate issues and/or bond bubble possibilities, we’re being forced to chew the least favorite flavors of gum for the current timeframe. This doesn’t mean you won’t be able to blow bubbles or receive coupons; it just means the coupons/bubbles aren’t going to be as big in the short-term. The good news is, however, that short-term strategies won’t allow the bubbles to become so big that when they pop, the mess doesn’t become this huge bond value loss. 

The Bond Bubble, in my view, is the most misunderstood part of managing a portfolio’s risk. Why? Possibly because many advisors and most clients seem to think bonds have no risk exposure, ever! Furthermore, many clients have a hard time comprehending that they can actually lose money in these so-called “safe, income-generating” investments (bonds).

That’s why I highly recommend that we, as advisors, assess our clients’ allocations in bonds, their maturities, fund durations, type of bond “flavors,” and look at diversifying the future bond risk exposure as much as possible. Whether we like it or not, the bond bubble is coming. It’s just a matter of how big we’ll let the bubble become in our clients’ portfolios before it bursts.

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