Bonds from Boom to Bust
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. The main 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. Equity 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 thirty 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% per annum for the next ten years (and in Germany, Singapore, Japan and elsewhere – even less).
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 towards bonds, arguing that prices are too high and must fall. 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 reduce 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 pick-up 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 (June 6), 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+year 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 co. 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 which the bond represents. Prechter believes that the wave towards 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 depression. 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 what 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 medium-term ones — are no longer the safest investments but are very dangerous. You have been warned.