Global agenda: Bonds from boom to bust
The core of the modern capital market is the bond market, also known as the debt market.
Yehoshua Matza (right), the CEO of Israel Bonds an Photo: Israel Bonds
The core of the modern capital market is the bond market, also known as the debt
market, where entities including governments (central and local), financial
institutions and large companies borrow money from investors.
difference between bonds and shares is the relationship between the investor and
the investee: Bond investors have much more modest expectations than their
equity counterparts; all they want from the investee is to pay them the interest
on the bond and then to pay off the principle when the time comes.
investors, who buy shares, become actual partners in the business and want it to
expand, make profits and become more valuable – and, of course, to give them
part of those profits in the form of dividends.
For 30 years, since
inflation peaked in 1981, the bond market has been in an underlying uptrend –
the longest and greatest boom ever. This means that the yield, or return, on
bonds has come down steadily over that time, from the record high levels of the
early eighties, to record low levels. Indeed, just last week, 10-year government
bonds in the US, Germany and a few other strong economies reached their
lowest-ever levels; in the American case, offering less than 1.5 percent per
annum for the next 10 years (even less in Germany, Singapore, Japan and
However, the rise in bond prices over the last few years (and
the parallel fall in bond yields – prices and yields move in opposite
directions; if you don’t understand why, just accept it as a fact of life) has
been the least-predicted event in the financial markets. Almost all the experts
have been scathing toward bonds, arguing that prices are too high and must
Why must this happen? Because the extraordinarily low yields
reflect a very low level of economic activity and/or a “flight to quality,” on
the part of scared and battered investors, from riskier assets such as shares.
In the US, household investors have consistently sold mutual funds investing in
shares over recent years and have moved money into bond funds. Institutions,
too, such as pension funds, have reduced the proportion of their assets in
equities and beefed up their bond portfolios.
The rationale for the
suspicion in which the experts held bonds was that any pickup of activity in the
economy would trigger stronger demand for investment funds and would push
inflation up. Both these forces would be detrimental to bonds. That was the
argument of the mainstream optimists. Over in the pessimist-apocalyptic camp,
the dominant view was that the massive effort by central banks to pump liquidity
into their economies would inevitably cause serious inflation, which is ruinous
for bonds, because these offer only nominal returns, which are vulnerable to
being “eaten up” by inflation.
Only a very small minority of analysts
have been bullish on bonds these past few years. One is David Rosenberg, a
“fundamental” economist whom I have often cited in this column. Another is
Robert Prechter, head of Elliot Wave International and a leading expert on and
proponent of the method of technical analysis known as Elliot Wave Theory.
Rosenberg has been bearish on the markets and developed economies in general for
many years, which is why he has been bullish on bonds. But Prechter has been
super-bearish, downright apocalyptic on the financial markets for much longer
than Rosenberg. He has therefore been extremely bullish on US Treasury bonds and
other issuers still regarded as “safe.”
But, as of Wednesday, Prechter
and his team have changed their position. They announced that they think the
recent high in prices and low in yields is the end of the 30-plus-years bull
market in bonds.
However, the reason they think bond prices are going to
fall is not because they are worried about in inflation; like Rosenberg,
Prechter and company are staunch deflationists and they haven’t changed their
minds on that. On the contrary, they are convinced that deflationary forces are
gathering strength everywhere.
That, they argue, is going to be the
problem with bonds. Remember, the basic requirement bond holders have from bond
issuers is to repay the loan that the bond represents. Prechter believes the
wave toward default, which is currently prominent in Greece but is in play
across the world, is going to get much, much stronger. Most companies and
governments will default in what he sees as the coming global
The efforts of the central banks to prevent will prove – are
proving – woefully insufficient. Bond prices will fall, in many cases very
significantly, because many issuers will go bust.
There is therefore,
finally, consensus among the apocalyptic analysts, both inflationists and
deflationists: Bonds are way overpriced and are terribly vulnerable to the
expected course of developments. Ironically, optimists reach the same conclusion
about bonds, although from the opposite direction. Whichever way you look at it,
bonds – primarily long- and mediumterm ones – are no longer the safest
investments but are very dangerous. You have been