When will the bond bubble finally burst?

By John Stepek

published 21 April 2015

in Features

150421-bond-bubble — The bond bubble - companies just aren't going bust like they used to

The bond market is in a bubble.

That much seems clear from the sheer number of unprecedented' events in the bond market.

Either the entire world has changed dramatically, or there's simply too much money chasing this particular asset class.

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As with all bubbles, it's probably a bit of both. A change in the environment made the asset class more attractive. But now it's reached the point where investors have been gripped by mania.

The big question is when does it all end?

Companies just aren't going bust like they used to

In other words, companies just aren't going bust the way they once did. As Dan McCrum on FT Alphaville sums up, defaults by single B' rated borrowers (that is, companies with pretty poor credit ratings) have been below the long-term average since 2002.

There was a financial crisis-related spike in 2009 as you might have expected but beyond that it's been sunshine and roses for risky' borrowers. "Between 1983 and 2002 the average default rate was 6.9%." Since then, if you take 2009 out, it has averaged below 1%.

A number of things lie behind this, notes McCrum. There's been "structural growth in the demand for fixed income" in other words, more and more people have been looking to invest in bonds. Borrowing costs have kept falling too. These factors "make it easier for a corporate borrower to refinance and survive".

People are also reaching for yield'. With central banks chasing everyone to take more risk, and inflation rates low, a borrower doesn't have to offer much of a return to look attractive.

How much longer can this continue?

Deutsche Bank's model which uses US ten-year Treasury yields as a lead indicator suggests that we won't see another spike in defaults until around about the end of 2017. "With unique levels and themes being seen in global fixed income on a weekly basis at the moment, we could be approaching a crossroads."

Meanwhile, US bond expert Jeff Gundlach of DoubleLine, who has arguably taken over from Bill Gross as the ultimate bond market guru, reckons on a similar timescale, reports Marketwatch.

He's concerned about rollovers' (where companies refinance their debt) in 2018 and 2019. If interest rates are starting to rise by then, the "quest for yield will cool down" and that means companies won't find it as easy to borrow cheaply.

Meanwhile, if companies' cash flow is unable to rise in line with their borrowing costs, then default rates could spike too.

As a result, the price of bonds would fall, potentially panicking investors and leading to "a run on bond funds".

So the experts seem to agree that there are maybe two years to go until the big bond-market reckoning. What does that mean for you as an investor?

My own view is that chasing bubbles is not a sensible investment strategy. As regular readers will know, I've not been keen on bonds for some time. And I'm not going to change my mind now.

Maybe this will keep rumbling along until 2018. But maybe inflation will surprise us all, or investors might lose faith in central banks' ability to keep control of markets. If that happens, I'd rather not be invested in assets that are already overvalued.

I'm not interested in buying negative-yielding government bonds in the hope that the price will go even higher, or that the currency gains will bail me out that's gambling, not investment.

If you're genuinely worried about deflation, then at these sorts of levels, you'd be better off holding cash in many cases, particularly as a private investor. Cash will deliver you a real' return during deflation.

And I'm not keen to take a punt on high-yield bonds, given that I can still get a pretty attractive dividend income for arguably not much more risk by buying a diversified portfolio of blue-chip stocks.

But I'd certainly hang on to a bit of gold in your portfolio, as insurance. If there's chaos in the financial markets, then the nice thing about gold is that it's an asset of last resort' its value doesn't depend on anyone else's credit record.

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.