Irrational Behavior In the Bond Market?

David B. Armstrong

I can't even begin to count the number of times I've come across the phrase "irrational behavior" in my career. I've not only studied it academically but also witnessed it firsthand. It seems that my encounters with both the phrase and the actual acts are countless.

Our behavior is shaped by trial and error and we generally learn from making mistakes and paying the price. If the price is painful, we tend to cautiously approach any similar situation in the future or flat out avoid it.

So why does it seem to me that irrational behavior by investors has time and again meant they simply can't avoid painful mistakes? The current bond market is a perfect example.

In my opinion, buying something with an expected rate of return that is negative fits the exact definition of irrational behavior--that's bonds in today's market. Recently, an investor could buy the 10-year U.S. Treasury bond with a yield of about 2 percent while the most recent decade's inflation rate was pushing 2.5 percent. So over 10 years, an investor would be receiving a real negative expected rate of return if inflation were to stay the same.

But investors seem to keep buying them and I don't know why. I'm imagining a call to a client that goes something like this, "Let's buy XYZ company stock. We will lose about 0.5 percent a year for the next 10 years, what do you think?" The response would be, "You're fired."

Investors seem to irrationally buy when things are in a bubble. Bubbles are OK for a while. There is plenty of research showing they can continue for a lot longer than most investors think they will. The challenge is not identifying a bubble, but deciding when to get out before it pops.

Need help identifying where we are in the current bond bubble beyond the fact that real returns on the 10-year are negative? How about recent comments from Dan Fuss, manager of the $66 billion Loomis Sayles Bond portfolio, who called it, "the most overbought [bond] market I have ever seen in my life in the business."

Fuss is 79 years old, by the way.

He goes on to say that it's not the end of the world for bonds and encourages people not to borrow money to buy bonds right now. Of course he is implying that he is witnessing investors actually borrowing money to buy more bonds.

Borrowing money to buy bonds that have a negative expected return is a serious sign of a bubble and a pretty good indicator that if you don't own them, now may not be the best time to start buying. You can write that down.

If you are currently holding bonds, you have a few options.

The first is to evaluate the coupon you are receiving, the maturity of the bond and your need for that income. Holding it until it matures is an option, but you need to be committed to that long time horizon.

Your second choice is to determine if you have a profit in your bonds. If so, consider selling them. When yields go up, they will go down in value and erode your profits. If you believe in buying low and selling high, now may be the right time. By the way, stocks still look cheap, even as we have closed in on record levels in most of the major U.S. indices. Warren Buffet, arguably the most successful investor around these days, is on the record recently with that exact sentiment.

It's true that there is money to be made in any bubble. But it's almost impossible to determine when a bubble will pop, as any investor who witnessed the tech bubble in the early 2000's or the recent housing bubble understands. The difficulty in identifying the very top is what makes getting out very difficult. It's hard to think about the fact that you may lose more upside.

But when investors are borrowing money to increase positions in a market that is as overbought as anything Dan Fuss has ever seen in his investing career, I think it's safe to say it's not a good time to buy and that any move to lighten up on your existing bonds will likely be a good one.

David B. Armstrong CFA, is a Managing Director and co-founder of Alexandria, VA-based Monument Wealth Management, a full service wealth management firm located in the Washington, DC area. David has been interviewed and featured in several national media sources and has been a speaker at several major industry conferences including Barron's Winner's Circle, IMCA, InsideETFs, LPL Financial Business Leaders Forum and LPL Financial Focus11. David and the rest of the Monument Wealth Management team can be followed on their blog at "Off The Wall", on Twitter @MonumentWealth, and on their Facebook page.