Finance professors teach that markets are rational. That thinking is probably dated because in large part market movements may not be rational. First, there is a herd mentality in markets that lead to irrational movements. Second, markets are affected by actions initiated by computer driven models which may be contrary to what an individual investor might do. Rationality is an interesting topic in today's markets. Now the nominal yield on Treasurys is close to zero which means that for long term bonds, the yields are likely to be negative when adjusted for inflation. Meanwhile, in Europe, many core bond markets are already have negative short-term yields and with the turmoil in the eurozone, inflows from Europe to Treasurys could push US rates negative. Why would a rational investor buy an instrument whose return is practically guaranteed to be zero? The textbook answer is "safety". The Treasury is a safe haven in a turbulent market fraught with uncertainty. Well that makes sense but who says the Treasury is safe? Sure it may be safe against default but it certainly is not safe from loss. Another strike against the rational market argument is that junk bonds are currently trading at record low rates. Of course this is because those rates of around 6 percent seem lofty compared to Treasurys. However, remember these are junk bonds we are talking about. Even in the best of times, junk bonds pose a risky bet for investors. Now in this economic climate we would expect the yields on these bonds to go up not down. But going down they are because of the miniscule return from Treasurys yet the risk has gone up not down. Who says markets are rational?
Harold A. Black is professor emeritus in the Department of Finance, University of Tennessee, Knoxville having retired after 24 years of service. He has served on the faculties of American University, Howard University, the University of North Carolina - Chapel Hill and the University of Florida. His government service includes the Office of the Comptroller of the Currency and as a Board Member of the National Credit Union Administration. He also has served on the boards of directors Home Savings of America and its parent company, H. F. Ahmanson & Co., Irwindale, California prior to its merger with Washington Mutual Savings Bank, on the board of New Century Financial Corporation, Irvine, California, then the nation’s largest real estate investment trust and as director and later chairman of the Nashville Branch of the Federal Reserve Bank of Atlanta. He writes an occasional article for the Knoxville News-Sentinel at http://www.knoxnews.com/staff/dr-harold-black/. His web page is haroldablackphd.com