When the bond bubble blows, it’ll take the stock market with it

published 10 March 2015

150310-bond-bubble — Companies are inflating another bond bubble right now

Here's a telling statistic. We all think of 2008 as a credit bubble. A disaster caused by debt.

Well, today companies are borrowing more than they ever did back then.

As the Financial Times points out, "companies issued $1.43trn of corporate bonds in the US last year, 27% more than was sold in 2007 at the height of the bubble."

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And investors are lapping it up (well, of course they are, otherwise the companies couldn't offload so many IOUs).

What's driving this? And more importantly, what happens when it stops?

Here's why companies borrow money to buy back their own shares

So if you can borrow at these rates, why wouldn't you?

Trouble is, what if you've nothing to spend the money on? I can see why you might not want to invest that money in expanding your business. The economy is recovering, according to the data, but where are the spectacular growth opportunities?

It's a hyper-competitive world out there. If an industry isn't being disintermediated' or disrupted' by some Silicon Valley Bond villain, then it's being pored over by regulators and consumer protection agencies.

Meanwhile, we're only one financial crisis away from going back to square one, or worse. And nobody knows how long the central banks can keep this money-printing stuff going on for.

So if you're a big company CEO with maybe a five-to-ten-year tenure and a yachting habit to feed, it's easier to play it safe.

But how do you keep that share price and that earnings per share (EPS) figure rising? That's where you're bonus comes from after all.

Easy: share buybacks. Borrow money and buy your own company's shares.That means there are fewer shares lying around, soearnings can stay static, yet earnings per share will still rise.

The company is no more attractive. In fact, it's riskier because it's more heavily indebted. But that doesn't matter today, because you've done the job you're incentivised to do you've pushed that all-important EPS figure up.

This is simplistic, of course. There are sometimes good reasons to borrow to buy your own shares. If you want to understand a share buyback scheme with an investor-friendly rationale, look at Next's share buyback.

But broadly speaking, it sums up your average rationale for share buybacks.

This can only go on for so long

But central banks have found that this is easier said than done. For a start, they're all trying to do the same thing; it's hard to debase your currency when almost everyone's at it.

It's also hard to get people to spend money when their incomes are static, their job security tenuous, and when they are already at or near their absolute limit as far as taking more debt on goes.

So cheap money has pushed up asset prices in all the ways we're by now familiar with. And dodgy incentives the preferential tax treatment of debt, combined with compensation packages that encourage short-termism on the part of company management have encouraged the replacement of equity with debt.

The thing is, this is now reaching such extremes that it's hard to see how much longer it can continue for. We're now seeing negative yields on many government bonds. And it's not just government bonds: some bonds issued by Nestle, for example, are trading on negative yields.

What happens when it all ends?

And yes, this is all ifs', buts' and maybes'. But the long run is against this continuing as well. As various people have noted in recent weeks, demographics are becoming less favourable for bonds.

As people age, they save more for retirement. But as they get beyond retirement age, they dis-save' in other words, they spend their pots. Put simply, that means selling bonds to spend their money. With our ever-ageing population, one of the tailwinds' for the bond market could soon turn into a headwind'.

What can you do? As usual, you need to make sure your portfolio is diversified. That involves having a range of equity market exposure, some bonds, some property, and some cash.

And all of this is the main reason I'd also still hang on to gold. It's had a miserable few years, but that's rather beside the point. It's there to act as insurance on part of your portfolio. And when everything else looks so expensive, it's hard to argue against the value of having a little insurance.

We'll be talking about all of this and many other things - at the next MoneyWeek conference. If you haven't got the date in your diary yet, put it down 12 June. You can find out more details here.

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.