Global Agenda: Are bonds a bubble?
What almost everyone is agreed upon is that the bond market is dangerous. This is a remarkable state of affairs by any standards.
Traders look at screens at a bank in Lisbon, Weds. Photo: Rafael Marchante/Reuters
The opening weeks of 2013 have seen the investing public, in the US and in most
other countries, pouring money into equity investments. The clearest evidence of
this was the data showing that the scale of purchases of mutual funds and ETFs
specializing in equity markets during January was the largest ever, and the
trend continued in the first few days of February. This is a major change from
the dominant theme in the financial markets in recent years, which has been the
relentless surge of money into the bond market while the general public has been
withdrawing money from equities.
While these facts are clear, their
implications have, as usual, been a matter of fierce debate. On the one hand,
the “bulls” have viewed this development as the belated realization by the
investing public that there is a bull market under way in equities, and that the
arrival of the individual investor in this market will “give it legs” – i.e.,
enable it to continue higher and for longer. The “bears” see the belated arrival
of the retail market as the death knell of the market’s ongoing rally because
the general public can be relied upon to display the worst possible timing –
buying shares when they are already high and selling them at the depths of the
But what almost everyone is agreed upon is that the bond market is
dangerous. This is a remarkable state of affairs by any standards. In theory,
bonds are safer than shares because they have elements of certainty that shares
lack. A bond carries a coupon that says how much interest the bondholder will
receive. More critically, a bond has a redemption date at which point the
bondholder will receive the principal amount of the loan in addition to the
regular interest payment.
Shares, in contrast, may have a dividend paid
on them, but there is no absolute commitment to the size or regularity of the
dividend payment; it could increase, decrease or disappear altogether, depending
on what the board of directors decides.
What is certain is that the
capital paid into the company by the initial purchasers of its shares will never
It is thus a thought-provoking reflection of the extraordinary
situation pertaining in the markets that bonds are considered, especially by
experts but even by laymen, to be more dangerous investments today than are
shares. The shallow element in the thinking behind this view is that short-term
interest rates are at zero and therefore have nowhere to go but up. Since bond
prices move inversely to bond yields (interest rates), it follows that all the
risk in bonds is to the downside; interest rates cannot fall further, so bond
prices cannot rise, but interest rates can and one day will rise, so bond prices
must eventually fall. Shares prices have no such dependence on interest rates,
therefore they are not similarly marked for decline.
This is a simplistic
view because the standard formula for valuing shares relates their price to the
value of the expected income stream that they will generate – and this future
income stream can only be calculated by discounting the future income at the
current “risk-free” rate of interest, defined as that available on government
bonds. Thus share value is implicitly linked to interest rates.
using this formula or anything similar to it, leads to the conclusion that if
bonds fall because of rising interest rates, then share prices will too, albeit
not necessarily at the same time and certainly not to the same extent – unless
the profits of the underlying companies rise by enough to offset the negative
impact of rising interest rates. This is possible but far from certain, let
Nevertheless, as a recent trip to the US made
abundantly clear, “everyone” now believes that bonds are dangerous because they
are “so high” – i.e., interest rates are so low and “must rise at some point.”
Indeed, because the coming fall in bonds is seen as “inevitable,” it has become
commonplace to describe the bonds market as “a bubble” because anything
considered overvalued and hence destined to decline in price is nowadays labeled
Whether this thinking lies behind the move into shares is
unclear because there has been no parallel massive move out of bonds. All that
has happened is that the flow INTO bonds has significantly slowed. But that may
still hide a move out of bonds by the general public because the Federal Reserve
is pumping no less than $85 billion into the American bond market every month
via purchases of government and agency debt.
The Japanese government has
now adopted an even more aggressive policy of reflation and, as discussed here a
few weeks ago, is seeking to create inflation and force the Japanese economy out
of its deflationary spiral. Yet so far, at least, this new policy has not had a
noticeable impact on the Japanese bond market – although it has had a massive
impact on the currency (a devaluation in excess of 20 percent) and on the share
market (a rise of similar magnitude).
This stands in sharp contrast to
the US, where long-term bond yields have been trending higher for many months,
despite the Fed’s announced intention of holding short-term rates at zero
through 2015 and pushing longer-term rates lower. If there is a bubble in any
bond market, it is in Japan, yet it is the American market that is showing
stress – so far.
Stay tuned because the bond market is the critical