Bond Bubble Explained Simply – What Could Happen Next?


Hi, I’m Jimmy in this video.
We’re gonna be looking at what many
people are calling one of the
largest bubbles ever.
They’re calling it the bond bubble.
So our question is, how did this
happen and what are some
potential ways that this whole thing
could end?
Okay. Now, I’m sure we’ve all seen
headlines like this,
and I’m sure that most of us know
the way that bond pricing works.
But just so we’re all on the same
page when the price of bond
goes up. Well, the yield of that
bond goes down.
And the same is true the other way
around. When yields go up,
the price of the bond goes down.
And this happens because generally
the interest paid on a bond stays
the same no matter what the current
interest rate is out in the market.
So if we have a five dollar coupon
payment, sometimes they
call this the interest payment.
Well, if the coupon payment is
five dollars on a yearly basis
and let’s say we pay 100 dollars for
that bond.
Well, clearly, if we take the five
and we divide it by hundred, we get
a five percent yield.
So now we own this bond and supply
and demand of the market takes
over the bond pricing.
And for some reason, a whole bunch
of people begin to sell the bond and
the price falls.
Maybe it falls all the way down to
ninety dollars a share.
Well, at the same time, the coupon
continues to pay five dollars
per year.
So now we have a dividend yield of
slightly over five and a half
percent.
And here’s where it gets
interesting. So now what?
Just like what’s happening in
reality today, the Federal Reserve
starts lowering interest rates.
And yes, our coupon is already
set. So we know we have to worry
about that changing on us.
But even if the Fed lowers
rates, it does. It’s not going to
affect our individual coupon because
we already own this bond, but it
very much does affect the value
of the bond itself.
And here’s why.
So investors generally like
higher yield and ideally
they like less risk.
So now Treasuries, which
the Fed is, is what the Fed is
trying to influence when they adjust
rates.
Well, treasuries, in theory,
are the invest the asset
class that have the least amount of
risk in them.
Maybe they were paying, let’s say,
two and a half percent and now
they’re down to one point seventy
five percent.
So some investors are simply
going to need a higher yield than
that. So they go out searching for
yield and maybe this bond
is one of the bonds that interested
in. So a bunch of buyers come in
and buy, start buying this bond.
And sure enough, because they have
more buyers and sellers, the price
begins to rise.
And as we know, as the price rises,
while the yield falls,
let’s pretend the price jumps all
the way to one hundred twenty
dollars.
Well, now the yield is about four
point one seven percent, all
the way down from 5 percent
when the bond was selling at one
hundred dollars.
So now we may be asking, where’s
the bubble?
And this can actually be a heated
debate among investors.
So for that, let’s switch over to
this chart.
This is a chart of the 10 year U.S.
Treasury bond going all the way back
to the early 90s.
So clearly rates have been
falling over the past few decades.
Well, at some point, they’re going
to have to rise.
Well, what happens to bond prices
when you start rising rates?
In fact, if we zoom in a bit just to
the past year, what with interest
rates below 2 percent.
Well, what would happen if bond
rates rose up
to, let’s say, just two and a half
percent? That half a percent
increase from the current level is
more than 25 percent higher.
Now, clearly, this would be a bad
thing for bond prices.
And it seems that this is a theory.
Rates have fallen way too much.
And because of that, so much
debt has been taking out.
And as that has happened,
we know that at some point rates are
going to have to rise.
What happens when they begin to rise
and you have an enormous bond
bubble?
Now, this may be true and that may
be exactly what happens.
But perhaps we should consider some
alternatives.
So the first alternative to consider
is when interest rates rise.
What if they go up, but they go up
slowly?
And if this if they do go
up slowly, does the bond bubble
still pop?
The answer may be yes.
Now, here’s a chart of the 10 year
Treasury going back just the past
five years.
And clearly, from the middle of 2016
to just recently, well, bond
rates were rising and the bond
bubble didn’t pop back then.
Now, clearly, a case can be made and
it’s probably a viable one that
rates didn’t go up enough to
cause the bond bubble to pop.
Well, at this time, they only rose
from about one point three or one
point four percent to a bit over
3 percent.
Sure, that’s more than double, but
it’s still less than a 2 percent
increase.
So maybe that wasn’t enough to
cause the bond bubble to actually
pop.
Now, it’s actually leads us into
scenario two for the bond
bubble in general.
What if rates don’t rise for a long
time now, I’ve heard a lot of
economists say that rates are at
historic lows and they simply have
to go up.
And this is true.
Rates are at historic lows and
there is a historic amount of debt.
And if we go around the globe.
Well, much of the world is sitting
at negative interest rates right
now. To illustrate, here’s a quick
example. And let me know if you see
any similarities between what
happened in this example and what
happened in the U.S..
So it’s the 1980s in Japan
and the economy was booming.
Real estate prices were taking off
all over the country and much of the
Japanese population found themselves
doing quite well and spending
accordingly.
Well, then moving it to 1990,
prices of real estate began
to show early signs,
early warning signs.
And in 1991, real estate
prices begin to collapse.
At the same time, the Japanese stock
market begins to class.
And just like that, Japan entered
what is known today as the lost
decade.
Now, granted, it could be argued
that the Bank of Japan took
too long to react and
to start lowering interest rates.
And perhaps that’s part
of the reason why the U.S., when
the U.S. ran into the very same
issues, was so aggressive
with loaning reduce interest rates
after the Great Recession.
But this is a chart of Japan’s 10
year treasury bond going back to
1991.
And as we may notice today, interest
rates are negative on the
Japanese 10 year treasury bond.
Now, if we would add the U.S.
10 year treasury to this, what we
can see some very similar.
There are some similarities here.
Now, I’m not bringing this out
because Japan’s interest rate
bonds is what the example
the world is after.
They’re just an example of where a
lot of the world is at.
Let’s add Germany to this as an
example.
How about the U.K.?
Well, as we could see, most
10 year treasury, most developed
countries look very similar to this.
And as the Japan chart
illustrates, Japan dropped below
2 percent right in this area.
And they stayed there when they
dropped below 2 percent for
in 1998.
Well, they stayed there for almost
20 years.
And that’s still it’s still there
today.
So this raises the question,
if rates are going to rise, when
are they going to rise?
Japan has been able to stay there
for a long, long time.
The U.S. just recently, just
over the past few years, crossed
below the twenty, the 2 percent
mark. So when does it begin to rise
as if five years, now, 10 years, 20
years it could be.
Now, this brings us to our final
point. Now we’re at a very unusual
point in history.
We’re in unchartered waters because
right now it’s estimated that there
is 19 trillion dollars,
about 19 trillion dollars in
debt that is tied to bonds
that currently have negative
interest rates.
So if we were to buy a bond
today that had a negative interest
rate, well, we’re almost certainly
guaranteeing that we will lose money
as that bond matures.
So what some economists are saying
is that what’s likely to happen is
investors are faced with this
scenario is that they’re going
to sell their bonds and either
hold cash or perhaps move to stocks
or real estate or some other
investment.
The point is they sell their bonds.
What happens if everybody starts
selling their bonds all at once?
Once again, the bond bubble pops.
So the prices begin to tumble
and panic begins.
So is this what’s going to happen?
It could be.
And like I said, the world has
never seen anything like this
before. These are unchartered
waters.
And I firmly believe that
a serious misstep by one of the
world’s major economies could
cause a ripple effect around the
globe. If that were to happen, who
knows where it would go?
But even knowing that,
I also know that the Federal Reserve
or the ECB or the Bank
of Japan or whoever it is,
could keep rates low
or at least raise them in a gradual
fashion.
It’s possible. Like we pointed out
with the Japan example, that it
stays there for a long time.
If they do. Does the bond bubble
really pop?
Because we can’t forget that bonds
are not the same as stocks,
because bonds have
a maturity date.
Bonds expire.
Most bonds have a fixed term
there. Their time period will end on
a predetermined date.
So as we know in our example,
well, we own the bond.
Let’s pretend that this is a bond of
a company and let’s pretend it’s a
Microsoft bond that we bought, let’s
say two years ago.
And that bond paid a coupon rate
of four point to five percent.
Well, this bond doesn’t expire till
2047.
Well, let’s imagine that right now
this bond is trading one hundred
twenty four dollars because a lot
of investors want bonds of good
companies.
So let’s imagine that interest
rates start rising and everybody
begins to sell this bond.
So when they do, for some reason,
we don’t sell.
We continue to hold this bond and
the price of this bond falls all
the way down to ninety dollars or
even eighty dollars.
Well, we we don’t have to sell.
So we decide not to.
Now if this were a stock, we’d be
down the same 20 dollars and maybe
we were willing to eat that loss
because we don’t know when the
falling will stop and we don’t know
if we’ll ever get our money back.
But with bonds, we do know
well, we’re at least more confident.
We know with this bond.
It ends in 2047.
And we know at that point we’re
going to get our principal back.
And in the meantime, we get to
collect our semiannual interest
payments of five dollars per year.
So we don’t have to sell.
We can simply sit here,
hold our bond until it expires.
And as long as Microsoft say
it stays a solvent company,
we can virtually guarantee ourselves
a profit on this whole trade.
A small one, sure, but a profit
nonetheless.
So I bring up this last part
here, because I just want to point
out the difference between a
potential bond bubble and what
a stock bubble could look like.
There’s going to be some buyers
that don’t feel the urgency
to flee out of the bond market
as easily as some feel flee
out of the stock market.
So those are a few examples of
some scenarios that I see that
could prevent a bond bubble
from bursting.
Of course, option four to this whole
thing is that the bond bubble
actually does burst.
And that would actually be scary
because there’s a ton of money
in the bond market, way more money
in the bond market than there is in
the stock market.
But what do you think?
Do you think that the bond bubble is
going to burst?
Do you think there even is a bond
bubble? Or will the
world just keep going?
Moves to the major developed
economies continue to move along
as they have been.
Do you think they will continue to
do that?
Is there a limited downside because
it’s the bond market like in our
Microsoft example, or does
the whole thing just go pop?
Please let me know what you think in
the comments below.
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all the way into the video.
Please post your comments below
because I’m really curious to see
them. I’m really curious to hear
what everybody’s opinion is on this.
Thanks so much for stick with me all
the way into the video.
I really do appreciate it.
I’ll see in the next video.
Thanks.

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