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How today’s two biggest investment fads are setting up the next crash

That bonds are so overvalued spells trouble for investors, says John Stepek. But thanks to the passive investing hype, that trouble could be about to turn into a disaster.

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Bond investors could be in for a rude shock

2017 Getty Images

I've written a lot about the bond market being in bubble territory.

I've also written a lot recently about passive investing being a financial technology that while wonderful in many ways is likely to exacerbate the next downturn. Particularly as more and more providers compete to hop on the passive bandwagon.

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What happens if we marry those two trends together?

Nothing good, I suspect.

A backgrounder on the bond bubble

Bonds can be bought on issuance in other words, when the issuer first asks for the loan. Or they can be bought and sold in the secondary market like stocks.

Assuming that you plan to hold a bond to maturity, you know exactly how much money you should get from the bond before you invest in it. You'll get the interest payments each year, plus the face value of the bond when it matures.

All you really need to think about is whether that sum of money represents a good deal or not compared to what you could get elsewhere.That involves thinking about the various risks, and how the bond fits with your existing portfolio.

There are a few risks that affect bonds. There's credit risk the danger that the bond issuer will default and fail to meet its obligations. There's interest rate risk the danger that interest rates will rise, driving the value of the bond down (if your bond pays a fixed amount of money each year, it stands to reason that it will become less desirable as interest rates available elsewhere go up).

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And there's inflation risk the risk that your real' (after-inflation) return will end up being a lot lower than you expected when you first invested in the bond.

So that's a rough and ready beginner's guide to bonds.

Now, as you might have noticed, interest rates are very low at the moment so low that we've seen some extremely odd things happen in the bond market in recent years. There are still several governments that can currently lend at negative interest rates. In other words, anyone buying their bonds and holding them to maturity will lose money (in nominal terms, at least, but probably in "real" terms too).

I'd go as far as to say that bonds have been in a bubble in other words, they've been irrationally overvalued and that we'll see some painful fallout from that when it all becomes clear.

One area where the fallout could be particularly painful is in the bond exchange-traded funds (ETF) arena.

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We like ETFs. We like passive funds. They represent a cheap and easy way to gain exposure to various assets. But right now we'd be wary of bond exposure in general, and probably more so in ETFs.

What duration is and why it matters

Why's that? The big issue is a thing called "duration". Explained simply, duration measures how sensitive a bond price is to a change in interest rates. The higher the duration, the more sensitive it is. Bonds with small coupons have higher durations than those with larger coupons, and bonds with more time to go until they mature have higher durations than those which mature sooner.

You can imagine bond duration as being like a see saw, with the bond price on one end and interest rates on the other. If your duration is low, then you're standing near the middle of the seesaw. If interest rates nudge up or down, you'll feel a bit of movement, but nothing drastic. And even if rates change a lot, you still won't move much.

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If your duration is high, on the other hand, you're out at the edge of the see saw. So if interest rates move even a little, you'll feel that move. And if they move a lot, you'll really feel it.

Clearly, a high-duration bond is riskier than a low-duration bond. There's more chance of something happening that will significantly affect the price over time. And given where interest rates are today, that "something" is surely more likely to be rising rates, than sharply falling ones.

So you might be starting to see the problem. Bond yields have gone down a lot. They're at rock-bottom levels. So duration is a lot higher today than it has been in the past. AsChiappinelli points out, the "Agg" is "now much more sensitive to a possible rise in bond yields" than it was even a few years ago, because of this "lower cushion' of coupons".

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But there's another problem too. Both governments and companies have been borrowing money (by issuing bonds) over longer periods of time. For example, Apple launched a 30-year bond for the first time last year. Why wouldn't you? If people are willing to lend you money at negligible interest rates and not demand it back until three decades hence that's a fantastic deal, for the borrower at least.

As a result of all this, says Chiappinelli, the duration of the "Agg" has risen by more than 60% since the financial crisis. In effect, investing in this bond index has become progressively riskier as bonds have become increasingly overpriced.

The sensible thing to do as a bond investor would be to cut back on your risk in other words, invest in shorter-maturity bonds. That's not what passive bond investors are doing right now, because of the structure of the underlying indices.

Now you can also argue that equities are expensive. And they are. And the fallout when they lose steam could be nasty too.

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However, at the end of the day, equities are volatile things, and two epic crashes in the last 20 years have amply demonstrated that. The level of passive investing in the market might exacerbate volatility when the market finally turns around and falls. But anyone who sees stocks fall by 20% or more in a year, and then claims that they weren't warned can only politely be described as remarkably uninformed.

Bonds on the other hand that's a different story. Bonds have consistently been sold and written about as a "safe" investment. That's because, in many ways, they are safer than equities. You stand in front of shareholders in the queue for your money. And assuming solvency, the cash flows are predictable.

But now you have people piling in to passive bond funds who don't understand anything beyond "bonds are safe". This is happening at a time when the major bond indices are becoming ever more risky.

It's also happening at a time when bonds offer next-to-no yield to compensate for potential future capital losses. That's a very different situation from previous bond crashes within living memory (and there really aren't many of them).

I don't know what might happen when a group of investors who think they've bought a safe asset open their portfolio statements one day and find they're down 10% or 20%. But I suspect it could be very messy, and I certainly wouldn't want to get caught up in the middle of it.

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