Investors are reaching for yield, at their peril

A trader looks at his screen

The global bond markets are verging on a bubble, which will likely result in a significant loss of principal value for major types of bonds by the end of 2017.

For many investors, the stock market seems overpriced, so they are seeking better returns in bonds, whether U.S. Treasurys, corporate junk bonds or emerging-markets securities. As buyers pour in, bond prices are soaring and yields (which decline as prices rise) are shrinking.

The situation verges on a bubble not only because bond yields are at historic lows, but also because investors are gravitating to lower-quality and longer-term bonds with higher risks. When these risks become realities, bond investors will flock to the exits—reducing liquidity and further depressing bond prices. If the bubble deflates, bond holders will experience deep declines in the current value of their bond portfolios.

The rate question

Let’s begin with the situation in U.S. Treasurys. Because of the unorthodox tactics of the Federal Reserve, including massive bond purchases, the yield on the 10-year Treasury bond was down below 1.4% in July, the lowest on record—even lower than in 1933, when the U.S. unemployment rate reached 25%.

To obtain higher yields, some investors have bought 30-year Treasury bonds. Yet the yield on these longer bonds is only 2.47%, down from 3% in January. If interest rates revert to January levels, the current value of $100,000 of these bonds will drop by over $10,000.

True, central banks in Europe have gone negative on interest rates, and the U.S. could do the same. But the Fed faces pressure to raise rates, and I believe it must relent. Rates are too low to be sustainable with improving economic trends. U.S. prices—the key driver of interest rates—have risen for most of the year in health care, housing and wages. These trends were reinforced by the Labor Department’s report that “core prices”—minus food and energy—rose 0.3% in August alone.

Investors face similar risks with junk bonds, those rated below investment grade. Very low yields make these bonds vulnerable to modest rises in interest rates. Between January and August, the current yields on double-B bonds fell to 4.5% from 6.8%; on single-B bonds, to 6% from 10%; and on triple-C, to 13.6% from 19.7%.

Moreover, many investors have gravitated to the “junkiest” of the junk—rated triple-C or lower. This rating means that bond defaults are likely or imminent. In the event of defaults, investors trying to sell junk bonds will find few buyers and face steep losses.

The overseas picture

Finally, yield-hungry U.S. investors have piled into emerging-markets bonds—again, creating huge interest-rate risks. Can you believe that the interest rate on 10-year Bulgarian bonds is 1.8%—only slightly higher than 10-year U.S. Treasury bonds?

The worst danger lurks in emerging-markets bonds issued in the currency of the local country. This raises two special risks for sizable U.S. bond funds.

First, if U.S. interest rates rise, the dollar will strengthen and local currencies will weaken. So these bonds’ value will fall on currency alone. Second, local-currency bond markets are thinly traded. If problems occur in these emerging markets, U.S. investors will not easily sell these bonds.

Some argue against a bond bubble because in theory people can’t expect that the value of a bond at maturity will rise. More pragmatically, they argue that investors in bonds tend to hold them for the long term.

But that ignores the reality of bond investment. Most investors aren’t willing to hold bonds for 20 to 30 years, so drops in current values have a negative impact over shorter periods. Also, many investors buy bonds through mutual funds, which effectively don’t have a fixed maturity date.

In short, with investors reaching for yield into low-quality bonds, small bumps in the road will cause significant portfolio losses. And the bigger threat lies on the highway ahead: The losses will multiply if central bankers hint that their massive support for bonds will diminish. So be careful before buying bonds; we are on the verge of a bubble.

Pozen has been a nonresident senior fellow at Brookings since 2010. In 2015, he generously committed to endow the Director’s Chair for the Urban-Brookings Tax Policy Center. Until 2010, Pozen was executive chairman of MFS Investment Management and, before 2002, served in various positions at Fidelity Investments. He did not receive financial support from any firm or person for this article or from any firm or person with a financial or political interest in this article. He is currently not an officer, director, or board member of any organization with an interest in this article.