Is the Bond Market About to Collapse

Similar to the stock market, investment in the bond market comes with a certain level of risk. Of course, there is corresponding reward. However, it is the underlying uncertainty and fluctuation that leads to near constant chatter about a collapse of the bond market.

As we begin a New Year and new presidency, there are more questions about the status and future of the bond market [1]. The biggest question being, whether the mounting signs of a bond market downturn are actually indicators of a bond market crash in the upcoming year?

Past and Present Premonitions

A severe downturn in the bond market or even a crash of the bond market was the talk of investors in 2011, 2012, and so on through the years. Every year it seems that one analyst or another eyes the bond market with suspicion and warns of investments in debt instruments. As recently as mid-2016, financial experts and investors further warned of a bond market collapse [2]. Yet, none of these premonitions of a crash have come to fruition.

Heading into 2017 the talk around the bond market is of a different sort. The results of the 2016 election reverberated across markets, but nowhere as decisively as the bond market [1]. The bond market seems to have a deep-seeded dislike for the upcoming Trump presidency.

Nearly every day since the election, the price of bonds fell. As the definition of the bond market below will show, decreased prices correlates to a rise in interest rates. This makes investors increasingly nervous and results in a need to sell environment, which further drops bond prices and creates premonitions of a crash [3]. 

Defining the Bond Market

To best understand what causes the bond market to fluctuate and why analysts feel uncertainty in its current status, it is necessary to know what the bond market is. The bond market is the trading, buying, and selling of debt securities such as government bonds, corporate bonds, or mutual stocks or bonds [4]. The purpose of trading bonds is an investment in the income when the debt instruments are repaid. This repayment includes both interest payments on the debt over time, and the full payment of the principle amount at the time of the debt instrument’s maturity.

Therefore, the risk of investing in the bond market is that the price of bonds will decrease as interest rates increase. This limits the rate that particular bond is traded on the market and decreases the return to the investor.

Effects of the Federal Interest Rate

One government decision that experts regularly warn will impact the bond market is an increase in interest rates by the Federal Reserve. The Federal Reserve increased the benchmark interest rate for federal bonds in December 2015 to 0.25% [5]. However, this was the sole increase by the Federal Reserve since June 2006, which was prior to the economic recession in the United States. Between 2006 and the end of 2015 the benchmark interest rate stayed stagnant at 0.00%.

The Federal Reserve is likely to raise the benchmark interest rate again. There is steady economic growth across the United States. This led Janet Yellen, the Federal Reserve Chair, to forecast another interest increase [5]. Where interest rates rise, the price of bonds generally falls. Thus, the Federal Reserve’s decision is certain to have an effect on the bond market in 2017.

However, in 2016 bond market did not tank, nor did the stock market for that matter. This makes it more difficult to predict what a 2017 interest rate increase will bring, but there seems to be less panic than before. Many people are still invested in riskier bonds, including long-term bonds with more exposure to a downward turn in the bond market [6].

Investor Preference for Stocks

For a number of years investors have been favoring bonds over stocks for many investment portfolios. There was a belief that bonds were a less risky investment than stocks [6]. This preference was particularly obvious in 2016, when the United States bond market saw $247.4 billion in investment [7]. On the other hand, stock funds only had a few weeks in 2016 with an increase in cash.

However, when stock funds see an influx of cash, it is usually because the money is pulled from bonds, and as expected the bond funds have lost ground. The incoming president has made promises of government spending on infrastructure, defense, and otherwise, potentially on a massive scale, which will lead to greater government debt and inflation.

Election of Republican President and Majority

The Republican victory in November, including the election of Donald Trump as president and a majority in the Senate and House of Representatives, has started to turn the markets around. There is renewed interest in stocks on the basis of relaxed federal regulations over corporations and lower corporate taxes [7].

The bond market’s reaction is a considerable amount of selling to avoid the anticipated effect on bond yields in 2017, under a Trump presidency [1]. Maybe more than any other market, the Trump election has affected bonds. There was so much movement on the bond market after the election that Treasury note rates went from 1.77% to 2.3%, an increase only seen three other times in the history of the United States [1].

Investors heavily invested in bond funds are moving with uncertainty, and it is expected that the first quarter of 2017 will see further decrease of bond prices. Yet, most investors, particularly those with well-diversified and middle risk portfolios, are not withdrawing from bonds entirely, and this indicates that market is not heading for a complete collapse.

Conclusion

There are certain market indicators that the bond market is going to struggle in 2017, particularly for long-term bondholders. These factors include the Federal Reserve looking to increase the benchmark interest rate, a surge in government spending, and a preference for stocks over bonds taking hold. However, as in years past it is unlikely that a bond market will crash in the upcoming year.

 

 

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