A South Sea bubble in bonds

If you want a reason to worry about today’s bond bubble, just look back a few centuries. The parallels are alarming for any bond investor. In 1694, the Bank of England was set up to take on Britain’s national debt (then £1.2m!), in exchange for annual interest of 8%, permission to do banking business and a licence to issue “legal tender” banknotes.

Then, in 1711, a competitor, the South Sea Company, was set up to finance government debts, incurred during the War of the Spanish Succession. It was promised a monopoly on future trade with the Spanish colonies of South America, assuming that Spain would lose its war with England. When Spain held on to its colonies, the South Sea Company’s fortunes faded, but only temporarily.

In 1720, it came up with the wheeze of swapping its shares, by then on the rise on the basis of exaggerated claims of new South Sea riches, for more national debt. A royal charter helped it consolidate its position. The shares rose tenfold before crashing. But for a while, it looked as if the government had found a perpetual motion machine for issuing debt – for free.

Fast forward nearly three centuries and we find Britain’s rulers employing a similar wheeze, only the national debt is now counted in trillions. The Bank of England has bought up much of the government’s recent new debt issues under QE. In November it said it would pass the interest on the bonds it holds back to the Treasury.

In effect, Britain (and the US, which has a similar scheme in place) gets to issue debt seemingly for free. Even if the central banks incur losses on their bond holdings in future, they can “record it as an accounting liability owed to the Treasury, which need never be paid back”, says Pimco’s Bill Gross. Central banks in Britain, America and Japan have made it clear they’ll keep rates low for as long as it takes to boost growth.

But there are now warning signs of a top-of-the-market rush into bonds as investors search for any form of yield in a zero-rate world. Five of the top seven European exchange-traded funds (ETFs) by sales last year were bond funds.

Irrespective of when rates start to move up again (in Britain the market only expects the base rate to rise from 0.5% late in 2014), it’s now mathematically impossible for bond prices to go much further. Downside risks are huge. The new South Sea-type manipulation of the bond market is one more reason to take cover and sell out.

• Paul Amery edits www.indexuniverse.eu, the top source of news and analyses on Europe’s ETF and index-fund market.

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