Have bond investors gone completely crazy?

In this country, bond investors are held in high esteem. Many people recognise them as the shrewdest guys in the markets. They are supposed to spot the big crises before they happen. And they have a reputation for calling out irresponsible governments and crazed stock investors.

But right now, government bonds are being bid up to truly crazy levels. And as prices go up, yields come down – they are practically zero in the cases of Germany, Switzerland and the US, as well as our very own gilts. That means that once you account for inflation, bondholders are all but guaranteed a loss.

Why do people keep buying these bonds?

Let’s take a look. Because this isn’t quite as crazy as it first appears.

Investment theory has gone into reverse

Not so long ago, bonds paid investors a reasonable rate of interest. In fact, they had to pay more than equity dividends for one very good reason: bonds don’t offer inflation protection.

The old rule of thumb used to be that inflation would whack the value of your bond’s capital in half every ten years. So you’d need an inflation-busting coupon to make up for it. And in the good old days, when equities were yielding, say, 3% or 5%, you could expect maybe 5% or 7% from bonds.

But today, with bonds so high, the yield gap (how much bonds should pay, above equity dividends) has gone into reverse. Today you can easily get 5% on an equity, yet sovereign bonds are paying out a couple of miserable percentage points. And yet, arguably, with an equity you are getting inflation protection too.

And on top of a decent yield, most big firms are sitting on potloads of cash – dividends are growing handsomely. Surely equities offer much better value than bonds?

Well, there are two schools of thought on this one. One that says equities are dangerous – it’s right and proper they should offer a decent reward for anyone mad enough to buy them.

And then there’s the other school of thought. Let’s get to that.

Can you handle a 30% or 50% loss?

The first and most obvious reason the so-called clever boys will gladly take a loss on government bonds is because the alternative may be far worse.

Many of the big boys see dangers in the financial system – it’s not just us! And if things do turn nasty, it’s arguably better to take a 2% hit on a government bond than face a 30% or 50% hit on equities.

And if the worst comes to the worst, we could see a horrible deflationary debt spiral. Basically, as people repay all their old debts, it sucks cash out of the economy – prices go down. And deflation is fantastic for bonds because holders could actually make a profit!

Though it seems unlikely – after all, the central banks are doing everything they can to avoid the debt deflation scenario – we must keep an open mind. Sure, losses on equities and debt deflation may be pushing up bonds. But I reckon it’s the second school of thought that really counts.

Don’t fight the Fed

You only need to turn your head towards Europe to see that things aren’t right. The crazy notion of stuffing 17 nations into a single currency regime is causing all sorts of mayhem. The authorities increasingly need to meddle in the financial markets just to keep an even keel.

Not so long ago, Greek, Spanish, or Italian bonds were all considered much the same – in fact, much the same as a German bund. And though the authorities are fighting tooth and nail to keep up the charade, the markets beg to differ.

Today, money is flooding away from the peripheries of Europe. And that cash has to go somewhere. So it floods into what are perceived as the stronger nations. The money heads into bonds and therefore pushes up prices – yields come down. But bond prices can’t go up forever. As we already said, at today’s prices these bonds are already all but guaranteeing a loss.

And bond investors aren’t dumb. There’s one more thing on their side.

The bonds that have performed best are the ones that are issued by nations most willing to print cash. The printing press means that authorities can always repay debt. In that sense a bond backed by a printing press is pretty much guaranteed. And that’s important for the guys with big bucks. In the event of a bank blow-up, as private investors, our cash is guaranteed to the tune of £85,000. The big boys have no such guarantee. To get that surety, they need to buy government bonds. And they’re happy to take a loss on their cash in order to get it.

What’s more, quantitative easing is a regime under which there’s always a buyer for these bonds. Effectively, the central banks promise to buy the bonds back at whatever price you want. They don’t care.

I guess the only question is, how much longer can this go on? I don’t know. But a long time is my best guess.

Does that make me a buyer of sovereign debt? No. I mean, the rewards are just too slim. In fact, the rewards are very likely to be negative.

But what’s really important is to consider why clever investors are willing to take a loss on government paper. Why aren’t they pumping cash into the obvious choice – equities?

It certainly gives me pause for thought.

I’m maintaining my portfolio 25% bonds, 25% equities, 25% commodities and 25% cash. I think this offers a reasonable margin of safety for whatever comes our way. Whatever it is keeping the City boys away from equities, it’s causing me some nervousness too. Don’t do anything rash!

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  • Rajeev

    Dear Bengt,
    You have to differentiate between bonds issued by good sovereigns and bad sovereigns. There are plenty of good sovereigns, eg Russia which pay a decent yield. The action however in the last three years has been in leveraged investment grade corporate bonds. We have known for last 3 years that interest rates will remain low for a very long time.Bernanke says so and I believe him.It has been a no brainer to leverage these bonds at an ltv of 70-80% which banks are willing to give on investment grade.Because money is cheap you can borrow at libor plus half and you dont have to worry about rising interest rates.Following this strategy has produced returns in excess of 20% per annum on very high calibre investment grade bonds. So bond investors are not crazy after all.Knowing what we know about Bernankes policies, buy and leverage investment grade.

  • Daniel Victor

    How,exactly,do you ‘invest’ in commodities ? You can buy physical gold – but that’s only one commodity.

  • DrD

    “Not so long ago, bonds paid investors a reasonable rate of interest. In fact, they had to pay more than equity dividends for one very good reason: bonds don’t offer inflation protection. “

    I always thought the opposite was true ie. traditionally you get more return on equities because of the higher risk you incur…

    An interesting article, but has left me more confused… But as the saying goes “if you’re not confused, you’re misinformed”

  • Rajeev

    Dear Daniel,
    Depends which commodities you want to invest in. If you want to invest in Agric. commodities have a look at an ETF called DBA.
    DYOR of course

  • bengt

    Dr D

    You have to go back to the 50’s or 60’s to find equities out-yielding bonds. I guess it’s all to do with fiat currency and inflation that bonds have been asked to do a lot more work. Up until the financial crisis that is!

    I didn’t want to confuse matters for this article. But if you take the long-view, you are right… technically the last forty years have seen a ‘reverse yield gap’ – where as you say the ‘traditional’ situation reversed.

    Maybe I’ve now confused the situation even more!

  • stevee

    Don’t forget that pension funds and large investors are buying to hold to maturity. So effectively they are hoarding value against risk, since only sovereign default can wipe out their holdings. On the other hand, something nasty happening in the Middle East could cream equity values at this stage in the cycle. So what you are seeing is excess cash in circulation being locked up again. Had the cash gone into anything else we would be in hyperinflation by this time. Relative yields has nothing to do with anything in this situation.

  • D MacDonald

    I believe the central bankers see massive deflation dead ahead (these people are not stupid) this is why they have all acted together to flood the world with cash and try to prevent an implosion like 2008. It’s also why insiders are cashing out.
    The central banks are all in to try and prevent a deflationary collapse.

  • EMS

    Economically there are 2 bets.
    Bet 1 is cash
    Bet 2 is precious metals
    Cash = a bet on deflation
    Gold = a bet on inflation.
    Looking at your portfolio you are sat firmly on the fence. I ask you the question when you apply the above then looking at your portfolio structure what are betting on? Second question are you aware that your written statements are in direct conflict with your investment holdings?

  • Clarinetplayer

    I am not wholly persuaded that those countries that are able to print money in the same currency in which they issue sovereign debt (e.g., the U.S.A, U.K., etc.) are therefore unlikely to default. Although this might be true in a technical sense – that is, the U.S. authorities can simply print all the dollars they want in order to redeem their promissory notes as they come due, thereby avoiding payment default – what would be the value of such a debased currency? After all, under this scenario domestic inflation in the U.S. would rise, pushing up the price of everything. Externally, the value of the USD would plummet against other currencies. In either case, the purchasing power of your dollar holdings would greatly diminish. So, although I might still be able to redeem my U.S. bonds at maturity, I would have to settle for USD of greatly dininished purchasing power. One might argue that this would constitute default by stealth.

  • bengt


    I hold a relatively diversified portfolio for the very reason that I don’t know what’s coming (and when!) I don’t see that as sitting on the fence.

    I suspect we’ll have inflation, deflation, bubbles and busts. I just plan to make the most of each as and when it happens. This is a 20 or 40 year game plan for me…. and right now, I’m sitting tight.

    Anyway, I think your analysis of gold/inflation and cash/deflation is simplistic. Gold can work very well during deflationary times – as debt is repudiated, gold can become a more valuable promise than cash.

    And you say “your written statements are in direct conflict with your investment holdings”

    Maybe it’s because I’ve confused matters by saying I hold 25% bonds – when regular readers will know that I really mean fixed interest. Government bonds are only 2% of my holding. I apologise for any confusion here.