Is there a bond bubble?

Wed 25 Sep 2019

Despite a recent selloff, $17tr in global bonds continue to trade with a negative yield. The spread between the US 10 Year Treasury rate and the Fed Funds Rate is negative and at the lowest level since the 2008 crisis. Germany may be paid to borrow for 30 years and the 10 year Bund is at the lowest level since East Germany re-joined the West. The 10-year yield for Greece, a country below-investment grade and no control over its currency which would help to pay off its debt, is almost 0.4% lower than the yield on the respective US bond, the only country whose “reserve currency” status allows it to print money with little or no inflationary implications. 

Meanwhile, borderline investment grade bonds (BBB) have surpassed the $7 trillion mark, suggesting that a lot of companies have been taking advantage of low rates, building up their debt. Unlike countries, most of which can print enough money to pay for their debentures, and who are never really ‘profitable’ enough to pay it off over the longer term (incredibly poorer countries who are forced to curtail spending have higher primary (ex-interest) surpluses), companies are expected to reduce their debt over time, as big debt ratios are usually a red flag for equity investors.

Why are investors flocking into bonds despite low yields? Partly because of the reversion in central bank rhetoric into a more dovish territory, and apparent lack of inflation, which have pushed yield curves down. Investors also assume people are flocking in bonds. The Fed has already cut rates twice this year and is widely expected to cut again by December. In September the ECB decided to restart QE, planning to buy €20bn per month for an indefinite period.

Still, negative yields make little sense. Investors lending money to the German government for 10 years are assured to lose 0.5% each year, or 5% if they hold until maturity. Why would anyone buy an investment guaranteed to lose money?

If the US Treasury is yielding 1.8% per annum at the time of crisis, it stands to reason that people preferring it to an equity expect less return from equities over the next ten years. Running a quick analysis of the S&P 500 (weekly data), suggests that the only times equities returned less than 1.8% pa for a 10-year period are the 70’s until 1982 (a dismal period for the global economy), and the 2008 Global Financial Crisis. So unless anyone is expecting runaway inflation ruining the global economy or another Lehman-like event, that pessimism may be misplaced.

The latter case, going for capital gains, is more probable. As buyers see the Fed extending its maturity reinvestment programme and the ECB restarting QE they feel a strong buyer will be present for bonds, so they would pile into, without expecting to hold the debenture until maturity. In essence, it’s ‘riding the bandwagon’ or ‘the greater fool theory’, a situation possibly exacerbated by momentum related algo-trading.

Does this mean that recent bond movements are a bubble? The rally certainly could last longer. Momentum is still positive for bonds, central bank dovishness isn’t going away anytime soon and global growth is set slow down further, hurting company earnings.

However, longer term investors should be warned. There’s a solid case to be made that bonds might be in bubble territory. At any rate they are much more expensive that equities or their own historic valuations.