Bond Bubble Alert! What You Should Do Now

Published in Investing on 6 September 2010

Gilt yields are at record lows. Avoid the potential bubble and look to these high quality shares instead. In 10 years time, you'll be glad.

Bond bubble talk is rife these days, particularly in the US. Things aren't looking much different here in the UK either, with 10-year gilts currently yielding a very lowly 3%.

Maybe it's because we've become, as one economist put it, "armageddon hypochondriacs." Recent experience leads us to believe that markets are always on the brink of insanity and meltdown.

Others disagree. Slate magazine's Daniel Gross, one of our favourite business writers, recently penned an article refuting the idea that US bonds are in bubble territory. It's a good read, but most of his arguments aren't terribly convincing.

Says Gross:

[B]ubbles are generally driven by greed and fearlessness. Investors jump in thinking they have nothing to lose and are certain they can get a massive return. ... But today's bond buyers are driven more by fear than by greed. They're not buying government bonds because they think they can double their money by December, or get a 50 percent return in a year by finding a series of greater fools. In fact, it's the opposite. US government bonds are the ultimate safe haven, the least bad place to invest. People are buying government bonds with paltry yields because they can't think of anything better to do with their cash.

We're not so sure. First, people used the same argument during the housing bubble: that investors were ploughing into property -- an apparent "safe haven" -- only because they couldn't think of a better place to put their cash after being burned by the dot-com bust. Not knowing what to do with your cash doesn't make you any smarter. Much less so, in fact.

And we don't think bubbles have to be associated with dreams of massive returns, so much as dreams of impossibilities and unlikelihoods. That can happen in fear bubbles, as some would characterise the driver of today's bond market as, in just as powerful a way as bullish ones. The driver of fear bubbles is the same attitude that drives bullish ones: Investors take an extreme event that prevailed in the recent past and extrapolate it into infinity. In either case, the result is lunacy.

The never ending story

With 10-year US Treasury rates well below 3%, what fear-driven hell is the bond market extrapolating into infinity today? A world with perpetually slow growth, negligible inflation, and central banks capable of keeping interest rates low by purchasing public debt by the trillions.

The last two points eventually become mutually exclusive (perhaps before long), which seems reason enough to think the bond market has lost its noodle.

That aside, the example most cite as justification for hibernating in bonds is Japan's infamous lost decade, where bond yields shrank to nothing in the '90s and have remained there ever since. Japan had a big deflationary recession. The US and UK have had a big deflationary recession. Thus, they say, our next 10 years should be just like their past 10.

But the differences between Japan and the US and UK are huge. Japan's citizens save like champions, allowing it to finance its own misery internally.

Not so here. The US and UK are dependant on the kindness of foreign strangers to finance their debt, a point that alone makes mimicking Japan's malaise far-fetched. We're comfortable predicting that foreign creditors will bail on us long before it has a chance to run debt near 200% of GDP, as Japan has. History bears this point out.

It's coming... Don't miss  out on your chance to join our exclusive share-tipping service. Guarantee your place on the next Champion Shares PRO enrolment!  Click to join our priority waiting list.

Speaking of issuing debt, here's Gross again:

[L]ook at the behavior of the peddlers of the allegedly bubbly securities. During bubbles, when foolish investors are willing to place high valuations on companies in a hot sector, entrepreneurs and managers rush to give the public what they want. ... In a bond bubble, when borrowing costs are exceptionally low, you'd expect the government to increase its borrowing significantly, taking advantage of the idiots by issuing new bonds like crazy. But that's not happening. The (US) federal government has actually borrowed less as bond yields have fallen -- much to the chagrin of liberal economists and progressives, who think the Obama administration is foolish not to borrow money at these insanely low rates and invest in high-speed rail, job creation, and infrastructure.

Not buying it. "Too little debt" isn't high on many sane people's list of government grievances.

In 2008 and 2009, the US Treasury issued a net $1.2 trillion and $1.4 trillion in debt securities, respectively. Both are roughly three times larger than the previous record set in 2003. When debt issuance triples previous records, it can't be accused of ignoring bond investors' insatiability, even if issuance has fallen in recent months.

Then there are corporations. Junk bond issuance around the globe is at an all-time high -- odd given the state of the economy. High-quality companies in the US from IBM to Johnson & Johnson have been issuing piles of debt at negligible interest rates, yet corporations are almost universally sitting idle on their cash.

Microsoft went into debt for the first time ever last year. Why? Not because it needed the cash -- it's famously burdened with too much of the stuff. A Microsoft spokesman happily admits the deal was simply "taking advantage of good market conditions." Ahem.

For people who don't own calculators

Whether bonds are a bubble or not is just a silly exercise in semantics. What's important is whether they're a good deal or not. And when compared with available alternatives, namely high-quality large-cap shares with high dividends, most are not.

Today, you can buy a 10-year gilts that yields 3%, or one of several high-quality companies, including Royal Dutch Shell (LSE: RDSB), British American Tobacco (LSE: BATS), and Vodafone (LSE: VOD), that yield close to double that.

No one knows if bonds are a true bubble. But what seems likely, extremely likely, is that 10 years from now, those buying bonds won't be nearly as happy as those buying high-quality shares. That's all you should care about.

More on the economy and the markets:

> For two weeks in September we will be opening the doors of our Champion Shares PRO newsletter service. In order to keep our exclusivity, only a select number of our readership will be able to join us. This is your chance to guarantee your place! Click here to join the priority waiting list.

> A version of this article, written by Morgan Housel, was originally published on Fool.com. Bruce Jackson, who has an interest in Microsoft, Johnson & Johnson, Shell and Vodafone, has updated it.

Share & subscribe

Comments

The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

TMFFlaneur 06 Sep 2010 , 9:35am

Good article, and I agree government bonds are looking bubbly, but I'm not sure we can say gloomy bond purchasers are 'extrapolating into infinity'.

After all, a very attractive feature of bonds is their known maturity. So at the very most, hell might only last 30 years or so...? ;)

BarrenFluffit 06 Sep 2010 , 10:16am

Bond holders do relatively well from deflation; is the market telling us how bad its going to be !

Luniversal 06 Sep 2010 , 11:44am

Before switching into VOD and RDSB, bondholders would do well to read TMFPhila aka Todd Wenning's careful mechanistic appraisal of the risks to their high yields, esp. Shell's. He gives BAT a higher score, but there are no dead certs in equity income.

A compromise, for security, might be the convertibles and prefs of these and other big companies, including zero prefs which can be rolled over tax-free under the CGT limit.

Sidekicker101 06 Sep 2010 , 3:13pm

Is there any chance of an article on corporate bonds at some point?
Might be interesting to discuss the risk vs equities and also corporate bonds come at higher yields than gilts.

F958B 06 Sep 2010 , 8:36pm

I suspect that in the longer term, bond holders will take serious *real* losses on their holdings.
But for the time being, the sheer amount of headlines about bond bubbles and imminent soaring interest rates makes the contrarian in me start to wonder whether the bond-bearish side of the trade has become crowded.

As I see it, without large pay rises, any increase in the cost of one item will mostly be offset by a reduction in demand (and therefore decline in price) for another, less important item.
If food costs go up, perhaps household goods prices will have to go down, since people will have to divert cash and/or prioritise purchases.

Until wages start to pick up, I don't see much risk to the *average* consumer price level, although I suspect that food and commodities will rise faster than other items.

Disclaimer:
I don't hold any bonds because of the longer-term inflation risk. I'm using high-yield, non-cyclical shares as a defensive/deflation option, with gold as an inflation hedge.

wokingblade 07 Sep 2010 , 1:45pm

Is there a simple way that Joe Public can short Gilts to take advantage or hedge in this situation?

Join the conversation

Please take note - some tags have changed.

Line breaks are converted automatically.

You may use the following tags in your post: [b]bolded text[/b], [i]italicised text[/i]. All other tags will be removed from your post.

If you want to add a link, please ensure you type it as http://www.fool.co.uk as opposed to www.fool.co.uk.

Hello stranger

To add your own comment, please login.

Not yet registered? Register now.