Bond Yields Look Bubblicious

11/08/2010 12:01 am EST

Focus: GLOBAL

Tom Slee

Retired- Financial Advisor, Money Manager, Gordon Pape Enterprises LTD

Fixed-income investors are signing up for real negative returns and risking huge capital losses, writes Tom Slee in The Income Investor.

Everything points to higher interest rates in the offing. Yet, people are still snapping up fixed-income securities as though there is no tomorrow. We are in the midst of an astonishing buying frenzy!

Forget about yields! On October 22nd, two-year US Treasuries were paying 0.35%, the lowest level since the Federal Reserve started tracking Treasuries in the early 1950s. But not to worry! There were plenty of buyers: After all, capital preservation is the name of the game.

Yet, this so-called “flight to safety” is self-defeating. The frantic demand is driving bond prices out of sight, making fixed-income issues hopelessly expensive and thereby increasing their risk. Prices are now so high that people are settling for negative returns. This has the hallmarks of a dangerous bond bubble. One thing is certain: There is going to be a day of reckoning.

During the eight months between last December and September 1st, US investors poured US$190.7 billion into bond funds and withdrew US$7 billion from equity funds. Yields are absurd, almost non-existent.

On August 3rd, IBM (NYSE: IBM) sold US$1.5 billion worth of three-year corporate bonds with a 1% coupon. Given that US inflation is running at about 1.25%, that amounted to a blatant negative yield even before taxes. Undeterred, investors snapped up the issue and even oversubscribed. It seems that they were happy to lock their money away with no return for three years.

[Meanwhile,] Johnson & Johnson (NYSE: JNJ) successfully sold ten-year bonds paying 2.95%. In other words, people were content to earn about 1.7% in real terms until 2020, assuming that inflation remains at present levels. Investors would earn a higher yield by investing in the common stock and have some capital gains potential as well.

Of course, bond investors may be right. Perhaps ten years of stagnation lie ahead, which would imply a period of deflation similar to Japan's experience. My feeling, however, is that our economy will recover and inflation will pick up steam. It's this probability that makes the bond bubble dangerous. Prices could plunge if investors become optimistic about the economy and equities.

Moreover, the correction is likely to be sharp and severe, especially as the fundamentals already point to higher interest rates. The astronomical global deficits will have to be funded at some point.

Take a look, for instance, at a recent report by Andrew Lilico, the respected chief economist at Policy Exchange, a UK think tank, and adviser to the British government. He believes that we are going to pay a price for the huge "money printing" that took place during the financial crisis and forecasts interest rates as high as 8% as early as 2012. John Gieve, a former deputy Governor of the Bank of England, agrees that rates are going to rise much faster than the market expects.

These are probably extreme views, but even if Mr. Lilico is half right, an upward surge in rates will be more than enough to burst the bubble. It's unlikely that the correction is going to be gradual and orderly. As a matter of fact, some observers think it's only a matter of time before a major holder of US Treasury bonds, such as China or Russia, abandons the sector and triggers widespread selling. A European government default could do the same thing. Indeed, with the US now facing deficits into the distant future, you have to wonder who is going to keep buying an endless stream of new Treasury notes.

You can see the danger. If, for any reason, rates suddenly soar, fixed-income investors are going to be locked in with large unrealized losses.
Are there any safeguards? My suggestion is [to] stay as short as possible and weighted with government issues for the time being. The inevitable correction is going to be much greater in the long end, especially among corporates, where bond prices react sharply to interest rate changes.

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