Are Bonds in a Bubble?

Burst your bubble

I’m not going to call it a bubble, but I wouldn’t personally buy into 10-year sovereign debt anywhere around the world.

This is what JPMorgan’s chief Jamie Dimon told CNBC last week.

‘…My view is the Fed is doing the right thing raising rates, telling people they’re going to start reducing the balance sheet.

The likely outcome is that it’ll be fine, particularly if the American economy is doing well. So if the Fed is doing these things in the face of a strong economy I don’t think it’s going to be that disruptive.

There is a chance it could be disruptive.

How likely is that chance?

According to former US Federal Reserve head Alan Greenspan, it’s extremely likely. Rising interest rates will absolutely be disruptive in Greenspan’s mind.

By any measure, real long-term interest rates are much too low and therefore unsustainable,’ Greenspan told Bloomberg on 1 August.

When they move higher they are likely to move reasonably fast. We are experiencing a bubble, not in stock prices but in bond prices. This is not discounted in the marketplace.

It’s not hard to see why many investors share Greenspan’s view. For so long, central bankers have bought bonds at a furious pace. But now, in the US at least, they want to start selling the darn things.

Is the global economy strong enough to sustain higher rates? Will the Fed and other central bankers hike rates too fast? How will debt-laden households survive?

Maybe I’m getting ahead of myself.

To understand why Greenspan believes bonds are in a bubble, let’s revise some basics.

Say you wanted to buy an Australian 10-year bond. Let’s assume the par value of the bond is $1,000 and it pays an annual coupon of 5%. This means you’ll receive $50 (0.05*1,000) each year for each bond you hold.

If you hold on for the full 10 years, you’ll receive $500 in coupons and the principle of the bond — $1,000.

But today is your lucky day. Thanks to sellers, the price of that same bond drops to $960. You’ll still receive $50 each year and $1,000 at maturity, but you only have to pay $960 today.

A bargain, right?

The yield of your investment is 5.2% (50/960).

Of course, the opposite could have happened. Too many buyers could have pushed the price of the bond higher, say to $1,040. Buying at $1,040 would lower the yield on the investment to 4.8% (50/1,040).

This is the price/yield relationship of a bond. The higher the price, the lower the yield and vice versa.

To affect the interest rates, central bankers head into the bond market, buying or selling, depending on where they’d like interest rates to go.

For example, to decrease interest rates, central bankers go on a bond-buying spree. Their buying activity drives prices up and pushes yields down. To increase interest rates, central bankers do the opposite. They offload government bonds, driving prices down and pushing yields up.

For decades, central bankers around the developed world have been doing the former.  They’re buying bonds in bulk, pushing prices up and driving yields down.

Take a look at the graph below. It shows the Australian 10-year bond yield over almost 50 years.

10 year bond yield

Source: Trading Economics

Since the early 1980s, the Aussie 10-year bond yield has been slowly declining. And as you probably know, it’s not just in Australia. Take a look at the US 10-year bond yield below.

US 10 year bond yield

Source: Bloomberg

So what will happen when central bankers decide to stop buying bonds and start selling them? Prices will fall and yields will rise.

This is why Greenspan and others believe bonds, especially US bonds, are in bubble territory. The Fed has already told the market it will be offloading bond stockpiles over the coming years.

The only question is: Will bond prices fall in sharp intervals or grind down slowly?

US fixed income traders are already on the lookout for irregular activity in the market. Take a look at the graph below.

Block trades on US bonds

Source: Bloomberg

They call them block trades. Like the name suggests, it’s when a huge block of bonds are either bought or sold. And because of low volumes, these block trades can have devastating effects.

According to Bloomberg, traders are now glued to their screens, watching out for block trades that could destroy existing positions.

But so what? If you don’t invest in bonds, what does it matter?

It’s a good question

But unlike Vegas, what happens in the bond market doesn’t stay in the bond market. Changes to the price and yield of bonds have real effects on stock prices.

For example, say bond yields significantly increased. Instead of 2.6%, imagine the Aussie 10-year was yielding 9%.

In addition to being an incredible risk-free return, a 9% yield might also mean bonds are cheap. So, even if you could potentially make 15-20% in stocks, you might not pass up a 9% yield with the possibility of selling your bond for a profit.

But if you did pass up on such an opportunity, there would be plenty of super funds and insurance companies that would, driving capital out of stocks and into bonds.

Of course, we are a long way away from a 9% yield. The US 10-year bond still only yields around 2.2%. The Aussie 10-year is slightly higher, yielding 2.6%.

I’m not about to say bonds will never yield 9% or higher again. But we might not reach that point within the next decade, especially in Australia.

The US is determined to lift interest rates despite low inflation. Yet in Australia, the Reserve Bank of Australia (RBA) hasn’t even started.

Low inflation, anaemic wage grow and high levels of household debt are preventing the RBA from lifting interest rates significantly.

Of course, you could simply hold on until maturity, and see whether there’s a decline in bond prices. But for the immediate future, it looks as if the best returns remain in the stock market.

Regards,

Härje Ronngard,

Junior Analyst, Markets & Money

Härje Ronngard

Härje Ronngard

Harje Ronngard is a Junior Analyst at Markets and Money.

With an academic background in finance and investments, Harje knows how simple, yet difficult investing can be. He has worked with a range of assets classes, from futures to equities. But he’s found his niche in equity valuation.  

Härje Ronngard

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