Avoid government bonds – here’s why

Three cheers for the European Central Bank (ECB).

Mario Draghi and chums are set to pump another load of free money into the European banking system tomorrow. This is happening via the ECB's answer to quantitative easing (QE) the LTRO (long-term refinancing operation).

I reckon banks will swallow up all they can, and that the bigger the number, the more cheerful markets will be. After all, the more money banks take, the more that will be pumped into dodgy eurozone debt, and on into broader markets.

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But governments should take advantage of the ECB's largesse while they can. Because after the Greek bail-out, investors are likely to be far more wary of ever investing in sovereign debt again

The ECB is printing money too

Banks are queuing up for their next batch of cheap money from the ECB. Analysts have no idea how much banks are going to ask for. According to Marketwatch, estimates range from around €200bn to around €1 trillion.

I suspect investors take all they can get. And I reckon that the bigger the batch of dosh they order in, the happier investors will be. Who cares if more money suggests more problems with banks' balance sheets? A big figure will be seen as more inflationary, and better for asset prices.

And make no mistake, the ECB's version of QE is helping with the eurozone's immediate problems. Italy and Spain have both seen their borrowing costs come down. Figures from the ECB show that this is down to Italian and Spanish banks piling into their sovereigns' debt in January. The ECB hasn't had to buy any government bonds itself for the past two weeks.

This all has a knock-on effect. As a result of improving sentiment, other investors have been happier to buy the European Union bonds that will be used to pay for the already-agreed Irish bail-out.

In short, the ECB is doing just what the Federal Reserve and the Bank of England are doing. It's slackening monetary policy. Indeed, as James Mackintosh points out in the Financial Times, "monetary policy is as easy as it has ever been".

That's great news for markets in the short term. And governments should take advantage. Because in the longer run, investors aren't going to be so keen to pick up their debt.

Government bonds are a bubble waiting for a pin

Why not? For that, we have to go back to the Greek deal. As James Saft point out on Reuters, "if the Greek bail-out has proved one thing it is this: we are now all creatures of government".

The rescue isn't important, as Saft notes. "It won't be the last and Greece's virtual default will become real one of these days." The real problem is the way that private investors have been treated differently to public sector investors. The ECB didn't have to take a haircut on its holding of Greek debt. Private holders did.

Saft notes that this sort of thing shouldn't be news to investors: after all, the banking sector is now subject to governmental whim. But changing the rules on government debt sets a far more wide-reaching precedent. Because "if this is the way business is done in Europe, with the co-operation of the IMF, why would Britain or the US be any different?"

So what's the end result? Technically speaking, investors should start to demand higher returns on government debt to compensate them for these risks. I say technically speaking', because if bond investors were as smart as everyone makes them out to be, you have to wonder why anyone ever lends money to Argentina.

This won't necessarily be a problem just now. In the short term, no one wants to stand in the way of central banks that's one lesson we should all have learned from the crisis by now but in the longer run, there could be real problems if inflation makes a serious comeback. As Saft notes: "one hint of inflation, one tremor of a financing scare outside of the euro zone, however, and the cost of mistreating investors will rapidly mount".

It's easy to dismiss the forces of inflation just now. Yes, we're all being squeezed by rising prices. But at the moment, these are acting more like taxes.

However, if central banks get their way, and manage to spur a recovery, then the inflation that could go along with that would wipe out holders of government bonds. Already, as Mackintosh points out, "rates are far too low in Germany they should be more than doubled, according to BNP Paribas calculations".

As Jeremy Grantham of GMO notes in his most recent quarterly letter, inflation can be painful for lots of asset classes, but stocks tend to get over it after the initial short-term surge. But for bonds, inflation is pure poison. On a ten-year basis, says Grantham, "surges in inflation have been a very slight issue for holders of equities (and gold) but a very serious one for bond holders".

I'm not even going to try to put a date on when the great bond blow-out might happen. It's like trying to call the top of the tech bubble in the 1990s. But I do know that I don't fancy having a lot of my money any of it, in fact sitting around in government bonds while I'm waiting for the day to arrive. That's not to say that all bonds are a waste of time in his free Right Side email, my colleague Bengt Saelensminde has been looking at some interesting corporate bonds recently but developed world sovereign debt certainly looks too risky to me.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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