I don’t know when the bond bubble will burst – but it’ll hurt when it does

Investors are buying government bonds that are guaranteed money-losers. Are they mad? Or is something else going on? John Stepek investigates.


Bonds bought from developed-country governments are seen as safe assets

Has the world gone mad?

A significant chunk of the investing population is now willing apparently to pay governments for the privilege of lending to them.

According to JP Morgan, reports the FT, around 16% of government bonds had negative yields last week.

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In other words, if you buy one of these bonds, and hold it to maturity, you end up getting back less money than you invested in the first place.

It's like lending an acquaintance £100, then telling them "you're such a good credit risk, and inflation is so low - I only need £95 back".

So what's going on?

Why would you buy a bond with a negative yield?

Firstly, bonds bought from developed-country governments that can print their own currencies are safe assets in nominal terms. In other words, if you buy then hold the bond until maturity, you know exactly how much money you'll get back.

The biggest risk is that inflation will take off, and the amount of money you get back is worth a lot less in real terms than when you bought the bond. But if inflation doesn't look like much of a problem (and right now it doesn't), this might not worry you.

And the shorter the time to maturity (ie until you get your money back), the less this matters that's why longer-term bonds tend to have higher yields than short-term ones.

So although the upside may look limited, so does the downside. If you're feeling worried about the future, or you need somewhere relatively safe to put a large amount of money, a bond offering a reasonably predictable level of mild downside could be attractive.

This is particularly the case when many central banks are turning deposit rates negative. So if you're a bank, and you have the choice between being charged to hold cash with the Swiss central bank, or buying a Swiss government bond with a slightly lower charge well, why not buy the bond?

Secondly, it's a way to bet on currency movements. A Swiss government bond might look like a poor investment if you're living in Switzerland. But if you would like to own Swiss franc assets because you think the franc is going to keep rising against the euro or the dollar or the pound or whatever your home currency is then buying Swiss government bonds offers a way to bet on this.

But maybe it's just a bubble

Our brains short circuit somewhat when we see that yields have turned negative. "How can that number go below zero?" we think.

But prices can just keep going up. If you have to buy a negative-yielding bond at £110 well, who cares, as long as someone else will buy it back off you at £111?

That might look kind of daft. But it's how bubbles always work. And to be fair, there are a lot of potential greater fools out there. Central banks are price-insensitive buyers. They'll take a negative-yield bond off your hands no problem.

And as Niko Panigirtzoglou of JP Morgan notes on FTAlphaville, passive bond funds will unquestioningly buy negative-yielding bonds too they just have to. So that's another price-insensitive buyer.

But there are also signs that this is self-reinforcing.

Look back to bubbles of the past. The Japan bubble and the (admittedly apocryphal, but plausible) story about central Japan being worth more than the entire state of California. The tech bubble, and investors being willing to pay millions for companies that were little more than scrawls on napkins.

These bubbles all started with rational ideas backing them. But eventually, there was no rational reason for buying this stuff, except that it kept going up. And in turn, because it kept going up, people then tried to invent fresh new rational' reasons to explain this away, because as human beings, we hate to exist in a world that we don't understand.

That's why "this time it's different" stories are such a warning sign they're a sign that things have got so far out of whack with reality that people are desperately wrestling to find ways to make sense of it all. When in fact, the simple truth is that it doesn't make sense.

To me, secular stagnation' theory and the general idea that we're in some sort of new normal', or that we are failing to make any sort of worthwhile technological progress, is a form of "this time it's different" story.

What could pop the bond bubble?

Why might that happen? It's not easy to say. But it is odd, when you think about it, to live in a world where we're talking about being close to full or at least normal employment in the major economies like Britain, the US, Germany and Japan, and yet we're also fretting about deflation and lack of wage pressure. Can that continue?

And there are plenty of other potential triggers. Dr Pippa Malmgren talks to Merryn Somerset Webb in the latest issue of MoneyWeek magazine, out now, about why she expects an inflation shock. If you're not already a subscriber, you can get your first four issues free here.

John Stepek

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He 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.

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.