Much ink has been spilt over the question of whether government bonds are in a bubble or not. The bond bubble believers love to cite stats along the lines that bonds are witnessing inflows at the same pace as equity funds did during the TMT bubble.
The bond lovers respond an asset with a finite life and no hope of limitless capital gain can't really be a "?bubble', and beside they argue the "?fundamentals' warrant current valuations. (i.e. inflation is low and will remain so). However, to me this is largely a sterile debate over semantics. The issue shouldn't be whether bond are a bubble or not, but rather are bonds a good investment or not? Ben Graham defined "An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative".
Do bonds offers long term investors a sensible level of return? I've always thought that in essence bond valuation is a rather simple process (at least one level). I generally view bonds as having three components: the real yield, expected inflation and an inflation risk premium.
The real yield can be measured in the market thanks to inflation-linked bonds. In the US, a 10 year Tip is trading at just under 1%. Expected inflation can be assessed in a variety of ways. We could use surveys, for instance, the Survey of Professional forecasters shows an expected inflation rate of just under 2.5% p.a. over the next decade. In contrast, the nominal bonds minus the TIP yields implies a figure of more like 1.5% p.a. The inflation swap market is implying a 2% p.a. inflation rate over the next ten years.
The inflation risk premium (a risk premium to compensate for the uncertainty of future inflation) is generally held to be between 25bps and 50bps. Given the uncertainties surrounding the impact of monetary and fiscal policy I'd argue that using the high end of that range seems reasonable.
Using these inputs a "?fair value' under normal inflation would be around 4%. Of course, this assumes that the current market 1% real yield is itself a "?fair price'. This seems like a questionable assumption to me. In the UK we have a longer history of index linked bonds "“ introduced in 1986. The average yield since the introduction is 2.6%, in the last decade the average real yield has been 1.5%. Given this "?parameter' uncertainty is would be reasonable to say that "?fair value' for 10 year bonds is somewhere in the range of 4-5%.
The current 2.5% yield on the US 10 year bond is clearly a long way short of this. So unless you believe that Japan is correct template for the US (i.e. inflation will be zero for the next decade), government bonds don't offer an attractive return as a buy and hold proposition.
Another way of looking at this problem is to ask how much weight the market is putting on a "?Japanese' outcome. Let's assume three states of the world (a gross simplification, but convenient). In the "?Normal' state of the world bonds sit at close to equilibrium, say 4.5%. Under a "?Japanese' outcome yields drop to 1%, and under an inflation outcome yield rise to 7.5% (this assumes a 5% inflation rate).
The table below lays out my own estimates (kind of an agnostic view, with a prior biased towards the "?Normal' but cognizant of the other two risks), then bond should yield around 4.4%. I can then tinker around with the probabilities to generate something close to the market's current pricing. In essence, the market is implying a 70% probability that the US turns Japanese.
It is possible to build a speculative case for bond investment (i.e. riding the deflationary news flow down), however, as ever this leaves participants with the conundrum of Cinderella's ball as described by Warren Buffett "The giddy participants all plan to leave just seconds before midnight. There is a problem though: They are dancing in a room in which the clocks have no hands!" Personally I prefer to stick to investment rather than speculation.
I think it is important to put your analysis in the context of the spectrum of investment options available to investors. It may be that government bonds are a bubble (though I happen to think the Japan scenario has a very high probability of happening in the U.S. – certainly over 50%). But where else do investors go for return? Certainly not the stock market which is really a ponzi scheme – decent returns are only achievable by successfully trading it and I don’t like my chances vs. the “house” (and I used to run a trading desk on wall street so that’s saying something). Commodites? Highly correlated to the stock market and volatile. Corporate bonds (including HY) – yields are low but I contend that decent returns can be had at lower risk than stocks.
Bottom line is it’s very difficult to get decent returns these days and, with the crappy economic outlook, capital preservation becomes a significant factor.
“The bond lovers respond an asset with a finite life and no hope of limitless capital gain can't really be a "?bubble'”
What’s the shelf life of a tulip bulb, again? A bubble implies irrationality almost by definition, particularly if one is using a long-term view. While participation may become less irrational if one’s time horizon is much shorter, that also means that the lifespan of the asset becomes largely irrelevant as long as it comfortably exceeds the holding period.
As to “limitless capital gain”, I’m not sure if there’s anything that has a realistic hope of that.
Agreed on semantics. Bonds are now a safe haven due to a lack of other investment opportunities which cause funds to flow into bonds, which lower rates, which creates capital gains, which attracts more funds into bonds. At some point the froth from the feedback loop will subside and the blush will come off the attractiveness of bonds. I don’t think that will equate to a bubble burst. Rather, it will reflect a cycle that went up a bit and then down a bit. Will the US go Japanese? Probable as long as nobody applied any imagination towards fixing the problem.
That being said, I have a great idea that would kickstart the beginning of a recovery.
*** Reinstate the itemized tax deduction for personal interest for perhaps three years.
People won’t be forced to refinance their homes to get the deduction – which is substantially impossible now for most since their homes are worth squat compared to before. If you have personal interest and you itemize, you get the deduction. Period. To put it cynically, the more you spend, the more you save courtesy of Keynesian economics. The cost to the Treasury might even be offset by a supply side effect for a couple of years, given the depressed nature of the economy at this time.
For this small effort, you make supply siders ecstatic because they will have a real example of the theory actually working. You boost credit. You boost sales. You boost employment. You boost GDP. You boost the stock market without HFT shenanigans needed. There’s no downside. Nada. Not a single one.
Now, somebody with access and influence … please sell this idea. It should be an easy sale if it gets heard by the right people.
“Personally I prefer to stick to investment rather than speculation.”
I guess that kinda rules out equities too…
People who own bond funds now will be able to look back and wonder why they believed talk about bonds not being a bubble because someone on CNBC said INDIVIDUAL bonds will return your – notional – capital value. Bond fund holders will get creamed.
The US equity markets are not a Ponzi scheme. Furthermore trading is NOT the way to maximize your returns in equities; asset allocation with re-balancing is the way to maximize your share of the return, think Jack Bogle.
Bonds look a tad rich right now …but if stocks break below the SP 1040 area–a quick run to the all time low yields at 2.00% (10yrs) could play out quicker than most believe. Long Bonds are volatile and always have been..Even in the current bull run over the past couple of years–it took some BIG nuts to hold long bonds as they swung from 2.50% to 4.80% and back now to 3.72%. Move duration down till you sleep well. Since the eighties, smart-rich guys like Jim Rogers have hated bonds. Smart rich guys can be wrong a long, long time. Retail doesn’t own a lot of T-bonds. What would happen if the treasury–to spur retail demand made them tax free to individuals?
I doubt retail investors are investing in bonds. More likely, bonds are perceived as a safe haven from the fear of a stock market crash brought on by recent experience. Bonds, not money market, are serving this function due to the reach for some yield. Retail investors are scrambling to lend their hard earned money to the US government, arguably the least credit worthy institution on the planet. Default will take place in the form of monetary inflation. I doubt many retail investors buying bonds today are expecting to hold them to maturity. How can they get out without tanking the price? I don’t see how this can end well.
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