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 andthe 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!

This article is taken from the free investment email The Right side. Sign up to The Right Side here.

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