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A bond market crash would be a disaster – but when will it happen?

With government bonds yielding less than inflation, prices must fall at some point. Phil Oakley explains the impact of a crash and asks whether you should be dumping your bonds now.

Bonds are not cheap.

Yields on government bonds IOUs issued by governments are currently below inflation, and they have been for some time. So people investing in bonds now are willing to take a loss in real' terms (that is, after inflation).

However, while I can see the arguments of those who say that bonds are in a bubble including my editor, John Stepek I'm not planning to empty my portfolio of bonds just yet.

The financial horror story of the century

Let's be clear: a bond market crash - where yields rise sharply and prices fall - would be very nasty indeed.

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Let's say that bond investors, fed up of lousy returns and being paid with funny money, decide that they want 2% more than inflation to hold British government debt (gilts). This is the sort of sum they used to want in days gone by.

So instead of a ten-year gilt yielding 1.86% to maturity as they do now, investors would suddenly demand 4.8%. To get to that point, bond prices would have to fall by nearly 25%.

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And if we were to go back to the mid-1990s and demand 7%, that would take a near-40% fall in ten-year gilt prices.

It's a very scary idea particularly as pension funds hold so many bonds.

Many personal pension funds adopt what is known as a life-styling approach'. This is where the provider shifts your money away from shares into bonds as you approach your retirement age. It is done to supposedly reduce risk.

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This is probably fine as long as they invest in bonds with short maturities (in other words, bonds that don't have long to go until they are paid back). These bonds are less sensitive to changes in interest rates, so a big move wouldn't affect their prices as much.

However, shifting money into general bond funds with longer maturities could see these types of funds lose a lot of money if there is a bond market crash. If you have one of these pension plans it might be worth making sure that you understand just how it works.

And it's not just bond investors who should worry. If you ask me, what I fear most in terms of my own pension fund, then without a doubt, it's a bond market crash. If bond yields rise, I think most investments will fall in value.

However, it's one thing to be concerned about a potential disaster in the bond market. The timing is quite another. Up until quite recently, I'd have argued that a bond market crash would happen very soon.

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But now I think it could take a long time to materialise. Central bankers will do what they can to prevent it happening, precisely because it would be a financial disaster. They will print money to buy bonds to keep yields low.

But the main reason a bond market crash might not happen soon is that there are strong deflationary trends everywhere. In fact, that's why central banks are printing so much money because they want to avoid falling prices.

Where's the inflation?

Most of the world has not yet recovered from the debt-fuelled binge of the nineties and noughties'. Apart from the US, where house prices have been allowed to fall and banks have written off lots of bad debts, most of the West is stuck in a debt trap.

Banks don't want to lend, and consumers - who already have too much debt - don't want to borrow. Companies have lots of spare cash, but they are not investing much of it. In many cases, it's mainly being used to pay dividends and buy back shares - which has been quite helpful for share prices in the short term.

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Throw in the fact that wages are hardly growing, unemployment is high, and there's a lot of spare industrial capacity - even more so if China's economy comes off the rails - and you have the ingredients for a big slump in economic activity.

And that's before we talk about huge government debts, ageing populations and unfunded social security programmes.

So despite huge amounts of money printing, consumer prices are hardly going through the roof (although I have sympathy with the view that official measures of inflation should be taken with a pinch of salt); the UK's inflation rate was lower last month, and commodity prices are coming down too.

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The only places where you are seeing inflation in fact, are in the prices of shares, property and bonds as money printing drives these higher. This helps to prop up the dodgy balance sheets of banks, but the money is not going into the pockets of the man in the street. And even if it was, it's doubtful whether it would be spent by enough people to push up inflation.

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Money printing may have stopped economies from collapsing, but economic growth has been weak, and inflation subdued. All of this highlights the huge deflationary headwinds we face. And as long as this continues, the bond market may not crack.

Indeed, if parts of the world turn Japanese, then who's to say that yields won't go below 1% if deflation takes hold?

So what do you do?

To me, the financial markets have become somewhat farcical. Daily movements in prices are based on views about how hard the printing presses will be run, more than any real economic factors such as profits. This may be fine for speculators who play games with other people's money, but it leaves the ordinary investor with lots of problems.

I can't predict what's going to happen in the future, and no one else can either. The fact is, we could have inflation or deflation. But one thing I do know is that there's a lot of danger out there now.

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That's why I'm not selling my bonds. And I'm not selling my shares either. By holding a diverse portfolio of assets and rebalancing them from time to time, I hope to have most potential outcomes covered. It won't entirely protect me from losing money if things get really bad nothing can - but I'll sleep a lot easier than if I bet my whole portfolio on one particular outcome.

This is also how I run my Lifetime Wealth newsletter portfolio. My aim particularly at these uncertain times is to protect and grow your wealth over the long run, by avoiding being wedded too strongly to one view. You can learn more about Lifetime Wealth here.

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

Lifetime Wealth is a regulated product issued by Fleet Street Publications Ltd.

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