In recent weeks the financial media has focused on the question of a “bond bubble.” This is the notion that bond prices have ascended to a level beyond reason and that the trend must soon be reversed. A common refrain is that interest rates will rise as inflation expectations mount; bond prices, which move inversely with interest rates, will fall and investors will suffer.
We avoid using metaphors such as “bubbles” to describe the results of our research. There is a long history of extreme and seemingly irrational cycles in capital markets, but these episodes are obvious only in retrospect. Instead of speculating about such occurrences, wise investors will construct portfolios under the assumption that security prices reflect a consensus view of millions of market participants acting rationally in their own self interest. Through their transactions security prices rapidly reflect the implications of emerging, random information (news). Prices therefore change randomly as well.
This notion is stated formally in the Efficient Market Hypothesis (EMH). EMH is often misinterpreted; it does not assert that prices are always and everywhere correct. We submit that current security prices are the simply the best approximation of intrinsic value, and while “mispricings” surely occur, they are not identifiable or predictable. Therefore no investor will consistently beat the market on a risk adjusted basis except by chance.
Empirical evidence demonstrates clearly that the majority of active bond managers fail to beat their market benchmarks (see chart, page 78). Investors should not reduce their exposure to fixed income securities in anticipation of higher interest rates. Rather, they should assume that current bond prices reflect this potential outcome.
The purpose of bonds is to provide portfolio stability. Investors’ fixed income holdings should be concentrated in high credit quality bonds of relatively short duration, which will limit price volatility.
Also in This Issue:
Quarterly Review of Investment Policy
How to Spend Wisely in Retirement
The High-Yield Dow Investment Strategy
Failure of Active Management
Recent Market Statistics
The Dow-Jones Industrials Ranked by Yield
Asset Class Investment Vehicles
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