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Streetwise Bond bubble talk: fear mongering, or fully justified?

A man creates bubbles on Woodbine Beach in Toronto.

Matthew Sherwood/The Globe and Mail

Fears that bond markets are caught in a bubble are both greatly exaggerated and entirely reasonable.

Those who argue the bubble is out of control can simply point to bond yields to prove their case. Ten-year U.S. Treasuries now pay less than 1.75 per cent annually and high-yield bonds can barely be called that any more. After their average returns recently dipped below 6 per cent, no one can argue investors are adequately compensated for the risk they're taking on.

Then there's the point that Jim Leech, the retiring chairman of Ontario Teachers' Pension Plan, made last week in an interview on Business News Network. Referring to chatter about a fixed-income bubble bursting, he said, "I heard that two years ago, and we've done really well in bonds [since]."

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On the flip side, the world looks a lot different today than it did when people investors started piling into bonds in 2009. The S&P 500 is on fire and the latest euro zone crisis took weeks, not months, to resolve. We're not out of the woods, but investors have much more reason to play the risk-on trade, and move from bonds to stocks.

So let's call a truce for now.

What we should really focus on instead is whether bond managers are prepared for when the bond market starts to sell off – because no security has ever stayed hot for eternity.

The timing of this inevitable shift hinges on when -- or if -- interest rates start to rise. Much like Canada's housing market, for which the finance department and the Bank of Canada have sounded the alarm on a condo bubble, buyers simply won't stop buying until the underlying fundamental – interest rates – forces them to reconsider their actions.

For bond markets, remember that it was a sudden rate hike that sent them into a tailspin in 1994 -- something the Financial Times recently revisited. After six straight years without a hike, the Federal Reserve, led by Alan Greenspan, surprised the market and raised rates, catching many portfolio managers off guard. The result: chaos, prompting countless funds to blow up.

These rates clearly weigh on investors' minds today. Though he doesn't think the market is vastly overheated, Mr. Leech told BNN that he's watching the situation "very, very carefully."

Other major funds are in the same boat, with some starting to come forward and warn the U.S. Federal Reserve Board that the third round of its quantitative easing program is distorting the market far too much. In an interview with the Financial Times, Rick Rieder, BlackRock's head of fixed-income investments, recently said that the Fed's program to buy $85-billion (U.S.) of Treasuries and mortgage-backed securities each month "has had a distorting effect on capital allocation decisions of all kinds at virtually every level of the economy."

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His request: cut the bond buying program in half, something the Fed seems amenable to of late. That way maybe some people will take their gains and run before a rate hike comes.

There is a saving grace. Unlike 1994, this time the market has much more information, and both the Bank of Canada and the Federal Reserve have set soft targets for when they would consider raising interest rates. (Ben Bernanke, for instance, wants to see unemployment drop below 7 per cent first.)

So this time we can telegraph a pending hike a little better. Plus Mr. Leech and many other major fixed-income investors simply can't cut and run from bonds because they need them to match their long-term liabilities with long-dated assets. He noted that if interest rates move by 1 per cent, Teachers' liabilities drop by $30-billion (Canadian), which is much more than the value of the fund's bond portfolios would drop under a similar hike.

But as always there will be people who are greedy and overexpose themselves to bonds for no good reason other than juicy returns. Let's just hope they don't manage money for unsuspecting retirees.

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(Tim Kiladze is a Globe and Mail Capital Markets Reporter.)

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