Is the hype around bonds just hot air?

Many experts look at the bond market as an indicator for future inflationary changes. Dominic McCormick argues recent events, particularly in the US, prove otherwise.

At a recent investment seminar, a fund manager at a large institution said he wasn’t worried about inflation developing as a problem in the US because their bond rates remained well behaved at close to historically low levels. In my view, this is flawed thinking on a number of levels.

Firstly, the bond market’s record of anticipating major changes in the inflation outlook is a pretty poor one. When inflation in the US began a long decline from a peak of almost 15 per cent in 1980, it took years for bonds to recognise that the trend had changed and to more fully reflect it.

The same was true of the prior rise in inflation from the late 1960s, through the 1970s. Bond rates generally only slowly follow big increases or decreases in inflation, they don’t anticipate them.

This is not a forecast, but if inflation were to begin moving significantly higher in coming years, don’t bother waiting for predictive signals from the bond market. By the time they are reacting to it, you can be sure that inflation is already a major problem.

Secondly, in recent times US bonds have hardly represented a free market, devoid of government or structural distortions. The most obvious intervention has been the two programs of quantitative easing where the US Federal Reserve has become the largest purchaser of treasury debt.

But even outside this there are also some structural rigidities in the US treasury market, particularly around the requirements for certain institutions (including banks, insurance companies and other government authorities) to hold ‘risk free’ AAA-rated treasury assets, irrespective of price.

Then there has been the massive build up of overseas reserve holdings of US treasuries, particularly by the Chinese who need to put the US dollars generated by their massive trade surpluses somewhere. 

The fund manager’s thinking above is indicative of a widely held view that the market for bonds is broadly efficient and their prices do a good job of discounting/anticipating the future. Given the distortions described above and the past record of bond markets anticipating major turning points, this view is seriously misplaced.

Credit risk

Thirdly, and perhaps more importantly in the current environment, it is not just inflation that is a big determinant of government bond rates. Increasingly credit/default risk is a major factor determining the level of even sovereign bond rates. While to date this has been a driving factor mainly for peripheral Europe, it increasingly looks like a story coming to other highly indebted countries like the US, UK and Japan.

Perhaps most alarmingly, the events in peripheral Europe have shown how quickly this perception of credit risk can change and dramatically impact the level of bond rates within weeks or months.

One only has to look at a graph of 10 year bond rates of various peripheral European countries to see this in action. Greek bonds moved from 8.5 per cent to 12.4 per cent within a few months in 2010, while Irish bonds rose from 11.3 per cent to 13.7 per cent and Portuguese from 10.6 per cent to 12.9 per cent most recently.

All three 10 year rates were around 5 per cent in mid-2009. Even Italian and Spanish bond yields haven’t been immune, surging more than 1 per cent over a few weeks recently. 

Could this happen to other bond markets of highly indebted countries, even when they are major economies? Why not?

Australia has been better placed because our sovereign debt levels are much lower and the absolute level of 10 year bonds rates has been relatively high. Still, Australian 10 year bond rates are now around 5 per cent and the current government is not inspiring confidence in the foreign holders that own the majority of these bonds.

Government bonds

In my view, one of the dumbest investments currently for the long term is a global government bond index product. The more debt a country owes the bigger weighting it has in the index.

For example, Japan, Europe, the US and the UK make up almost 95 per cent of one of the commonly used indexes, the Citigroup World Government Bond index. The yield on this index is a little over 2 per cent per annum.

Of course you pick up the interest rate differential through currency hedging which currently adds a few percent per annum to the low ongoing yield, but this will not protect you from serious capital losses if there is a significant move up from the current low level of bond rates in these countries.

This is also assuming that none of the underlying countries default, which is far from certain these days. Investing in this type of fund reminds me of the proverbial “picking up pennies in front of the steamroller”. Still, this hasn’t stopped many global government bond index funds, or low tracking error funds, ranking highly amongst the various research houses. 

Global impact

In many respects, it is the US bond market that is critical because it has become a key lynchpin of global financial markets. US treasuries are the world’s ‘risk free’ rate, the asset that most other assets are priced off, one of the most liquid markets globally and the collateral used for many transactions.

A major downgrading of US bonds - whether formally by rating agencies or informally by the markets requiring much higher yields - would have a massive impact, not just on investment portfolios, but on the global financial system itself.

Indeed, this impact would likely be much more significant than the dramatic increase in bond rates in the 1970s. It would leave the global financial system somewhat rudderless and in search of other riskless assets and benchmarks.

Risk premiums across all asset classes would likely rise at least for a period until markets adjusted to a radically different environment, in which the position of the US as the reserve currency and centre of the global financial system would be challenged.

This is not some apocalyptic fantasy. The political circus over raising the US debt ceiling is demonstrating just how difficult real progress to actually decrease the US public debt burden and move to a sustainable long term fiscal track will be in the US.

It is easy to conclude that the only thing that will really bring about the necessary major hard decisions is a market crisis. That is, holders will lose confidence in US bonds and the market will start demanding significantly higher rates.

However, as has been shown in the European situation, this rise in rates can actually accentuate the crisis as the higher cost of debt makes balancing the budget even harder.

Some say this won’t happen because China, which owns US$1.6 trillion in US debt, would never let the value of its reserves be so badly impacted. This is wishful thinking. The Chinese alone don’t set the price of bonds and in any case have been gradually working towards deploying their reserves into other investment areas.

US bonds rates

Could we therefore see a dramatic rise in US bonds rates where, from current low levels – below three per cent on the 10 years - they double or even triple over a period of weeks, months or a few years? It certainly cannot be ruled out as one possible endgame for the current dilemma.

It is true that as one of the lower taxed countries globally, the US could solve its fiscal issues over time with some hard decisions. It also has greater flexibility than most given that all the debt is in their own currency and they can also help ‘manage’ the debt by currency debasement and inflation.

However, these latter solutions are not good ones for holders of bonds, as they will lead to very poor real returns.

The investment portfolio implications of big moves in the US and other bond interest rates would be profound. When something perceived as ‘risk free’ fails or severely disappoints, it has a much bigger impact than failure of those areas already perceived to be risky. Investment implications would include: 

• De-rating of other financial assets, including shares, as bonds eventually become more attractive at higher interest rates; 
• A period of uncertainty, which would lead to investors chasing other ‘safe haven’ or lower risk assets. Possible candidates would include the corporate debt of the world’s largest, safest companies, the few available lowly indebted governments and various hard assets such as gold, and 
• Continued risk aversion among retail investors in particular who would stick to the safety of cash and term deposits despite low returns.

Arguably, some de-rating of shares has already occurred, as investors grow cautious over the various macro risks – including, but not limited to, sovereign debt – even if these problems/risks have not been fully reflected in certain bond markets at this point.

What about the positive arguments for US bonds? Deflation is still a risk. Why couldn’t US bond rates go much lower – even to the 1 per cent rates of Japanese 10 year bonds?

Also, bonds are already a very ‘out of favour’ asset amongst institutional investors, so from a contrarian point of view doesn’t this make them attractive?

Anything is possible and an extended Japanese-like deflationary situation cannot be ruled out. However, the US clearly has been much more aggressive in fighting deflation than Japan ever was.

And unlike Japan, a significant component of US bonds is owned by foreign investors who are likely to be less loyal when the going gets rough.

Finally, because many bond markets are not operating in a truly free market, one should discount arguments suggesting that the negative investor sentiment towards them is causing them to be priced at attractive values.

Arguably, many of the US (and other) bonds are being held and bought for non-investment reasons (e.g. quantitative easing, AAA rating, trade imbalances, etc.) rather than as a judgement of whether they offer good value.

On balance then, the medium to long-term bullish case for bonds is weak and would only be realised in the narrowest of scenarios. In any case, the gains to be realised are relatively small compared to the potential losses in the more adverse scenarios.

However, there is no certainty that the negative scenario for US bonds, even if ultimately proven correct, will play out in the near term. The US public debt has been growing for 30 years, why would markets lose confidence now?

Crisis time

Having said that, there are a number of reasons why a crisis may be close at hand. Firstly, it is only in the last year that peripheral Europe has shown, for the first time in more than half a century, the first-hand market consequences of a loss of confidence in developed country sovereign debt.

Markets have a tendency to extrapolate the experience of one country to others with similar characteristics, at least over time.

Secondly, the ratings agencies, criticised for their slow reaction and inherent conflicts in previous corporate and structured debt failures, are losing patience and keen to demonstrate their newfound objectiveness.

Government bonds generally, and US bonds particularly, were an asset class that in hindsight, you wanted to own a lot of in 2008. Increasingly, the signs are that not only will these bonds not deliver in the next crisis but also that they could well be at the centre of it. Investing via the rear vision mirror, which is the essence of passive/index investing, has never been so dangerous.

Dominic McCormick is the chief executive officer of Select Asset Management Limited.