If there’s going to be trouble this year, here’s where it’ll come from

published 2 January 2014

14-01-02-markets — Bond markets are looking frothy

Happy New Year! Welcome back. Here's hoping it's a good year for us all.

As far as investment goes, I have to say, I'm pretty optimistic at this point at least. Stocks in many countries are at or near multi-year or even record highs. But I'm happy to stick with the markets we've been recommending, such as Japan and the eurozone.

There's sufficient scepticism out there on stocks particularly in markets that are still cheap to make me think that there are plenty more buyers waiting to be converted.

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If there's a potential fly in the ointment, it lies elsewhere. If we're going to get any nasty shocks this year, the bond market is where they'll erupt...

The biggest myth about bubbles

One of the biggest is that no one or very few people see them coming. Bubbles, by their nature, stick out like a sore thumb.

Now, just because you can see one, doesn't mean you can take advantage of it. It's very hard to tell when they'll pop, which is what makes bubbles so dangerous.

But the idea that investors are all true believers when they buy into these investment fads is just wrong.

GMO's Jeremy Grantham tells a story about the tech bubble that I've related here before. The short version is that, shortly before the dotcom bubble burst, he asked a large group of his peers if any of them expected the good times to last. More than 90% said no.

The reason they were taking part in the bubble is that they'd rather enjoy today's gains and worry about the fallout later, than to sit the bubble out and deal with angry clients on a daily basis.

In other words, for many professional investors who dominate the market it's rational to take part in both a bubble and a bust, rather than try to avoid it. Apart from anything else, fads are a fantastic sales tool. Everyone loves a great story, and it's easy to sell funds off the back of an exciting theme, rather than a vague promise of capital preservation.

Sure, there are some true believers who really think that things have changed forever. But half of the time, the new paradigm' arguments come from people who are trying to find a rationale to keep buying or rather, one that sounds better than "we're still buying because everyone else is".

The bond market looks very frothy indeed

There's an interesting piece in the FT this morning, citing some of the more worrying signs of over-exuberance in the bond market. "Issuance of syndicated leveraged loans those made to companies that already carry high debt loads reached $535.2bn in 2013. That is just shy of the $604.2bn sold in 2007."

Meanwhile, in 2007, covenant-lite' loans, which carry less protection for lenders, accounted for 25% of loans sold. In 2013, they accounted for almost 60%.

And sales of payment-in-kind' notes which allow borrowers to repay lenders with more IOUs have already hit a fresh post-2008 record. As have sales of the absolute junkiest of junk bonds those rated triple C'.

As Russ Koestrick of BlackRock tells the FT, there's plenty of money available for these companies to borrow. So they can roll over' their debts if necessary, meaning no one is desperately worried about lending to them.

However, that sounds a lot like a greater fool' argument "I'll lend to this guy because there's always going to be someone daft enough to stump up more cash if he gets into trouble."

So what's the real reason for all this rubbish being bought so readily? It comes down to a shortage of supply. With central banks buying up government bonds, notes the FT, "annual net issuance of financial assets is hovering around $1trn far lower than the $3trn-$4trn sold in the years before the crisis".

So the safe' high-quality stuff that investors would normally be buying simply isn't there. They need to put their money somewhere, and all that's available is riskier stuff. This is how quantitative easing (QE) works. Of course, the thing is, QE in the US at least - is set to go into reverse.

So you have to wonder what will happen when more of the safe' stuff becomes available to buy again, and likely at higher yields too. That could make all the junk look very expensive indeed by comparison.

Now, I'm not sure this will end up being a big issue this year. I suspect QE will take longer to unwind than many expect. But even if it doesn't, the sensible thing to do as an investor is to stick with the strategy of buying what's cheap. And most areas of the bond market look anything but cheap.

So that's an area where you should keep your exposure low. As for what to buy - our experts give their views on the markets, themes and stocks to buy for 2014 in the next issue of MoneyWeek magazine, out on Saturday (as opposed to the usual Friday back to normal service from next week). If you're not already a subscriber, subscribe to MoneyWeek magazine.

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John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.