Generally speaking, I consider something in a bubble when it meets three criteria: First, there has to be some “game-changing event” that occurs that alters people’s behavior. Second, a buying frenzy develops that pushes normal asset allocation practices out the window and prices to unreasonable levels. Third, the fundamentally weakest part of the market sees massive inflows of investment and typical risk/reward relationships are ignored as greed sets in.
It’s no secret I think we’re in a bond bubble: The Fed crushing rates to 0% and starting QE was the game-changing event that altered people’s behavior (the first criteria). Treasurys have seen massive inflows at the expense of other assets, and given the fundamentals are now (most would admit) overvalued (the second criteria). Finally, junk bonds are being bought with both hands, and yesterday the average yield on junk bonds fell below 5% for the first time ever, as yield-starved investors throw money into low-rated companies in an effort to generate income (the third criteria).
Some will justify the low yields based on the fact that investment grade bonds yields are also very low, and the spread between the two isn’t compressing substantially. But, it is compressing, and if we use our common sense, we can see that risk isn’t being accurately priced at these absolute yield levels in junk bonds (a triple B– company is still just as risky on a ratings basis as it was when junk yields were higher).
Bubbles are all about the suspension of the proper pricing of risk—and I believe we’re seeing it in the junk market. I’m not saying that junk bonds yields trading below 5% is akin to subprime loans trading where they were in the heights of the real estate bubble, but I’m just pointing out that, in my mind, all the criteria of a bubble have now been met by the bond market.
I don’t know when it’ll pop any better than anyone else—I just think it’s worth pointing out that the warning signs here are getting louder, and the “smart” money is quieting moving towards the door. Food for thought.