Bonds are in a massive bubble – but what can you do about it?

Bonds are in a bubble. With yields at their lowest in history, they offer incredibly poor value. But no one can tell when it will burst. The good news is, says John Stepek, that it doesn't matter.

When will the bond bubble burst?

If there's one question that investors today most want an answer to, it's this one.

You can see why. If bond prices fall, it'll cause havoc throughout the wider economy, as borrowing costs rise.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

And the sector certainly looks very bubbly. There's no denying that.

But as to when precisely the bubble will pop sadly no one can answer that question.

The good news is that as far as your money goes, it doesn't matter.

There's a far more important question to ask, which is much, much easier to answer

When will the bond bubble burst?

The bond market is unquestionably in bubble territory.

In the government sector, gilt yields (UK government debt) are near their lowest levels on record. Same goes for the US, and many other developed countries. This is even although national balance sheets have rarely been in worse shape, particularly if you ignore periods of all-out war.

Meanwhile, in the corporate bond area, companies are able to borrow at an all-time low average yield of 3.3%, according to Barclays. Overall, says the FT, the amount of debt issued is on course to hit a record this year, of more than $1.7 trillion.

Supply of debt is rocketing in other words. Yet the value of debt is soaring too (as yields fall, bond prices rise), because investors just can't get enough of it. UK pension funds have more of their money in bonds than in equities for the first time in 50 years or so.

These are all ugly signs. Bonds by and large offer incredibly poor value, yet investors are still piling into them.

But when will it end? This is where it gets tricky.

I've spent a fair bit of time over the years looking at contrarian sentiment indicators to try to see if there's anything that reliably acts as a sign of a big turning point. I have to admit, I can't find one.

Bond funds are very popular. But they've been popular for quite some time now. Which particular month will mark the tipping point? I don't know.

As for press coverage: there are plenty of people out there willing to say that bonds are in bubble territory. Yes, lots of them are equity managers, so will never want you to put your money in bonds. But it's hard to argue that no one expects bond prices to fall - eventually.

Even screaming' contrarian indicators like big, bold headlines on magazine covers don't work as well as everyone thinks.

Remember that BusinessWeek death of equities' magazine cover that everyone talks about? This was back in the late 1970s. Inflation had destroyed investor interest in stocks at the time.

The US magazine put out a cover story arguing that "the US economy probably has to regard the death of equities as [a] near-permanent condition". You can read the story here and you really should it is a fascinating lesson in how what seems an incredibly compelling argument can turn out to be very wrong.

Anyway, the story turned out to be wrong in that a two-decade bull market in stocks kicked off in the 1980s. So the cover is often cited as the ultimate contrarian indicator. So much so, that these days, from the way everyone talks about it, it's easy to assume that BusinessWeek nailed the rock bottom in stocks.

Yet when you look at the reality, in terms of timing, it wasn't that great, as Bespoke Investment Group points out. The story came out in August 1979. The full-blown bull market in US stocks didn't actually start until August 1982. At that point, three years later, the S&P 500 was still around 5% lower than where it was when the BusinessWeek story was published.

In hindsight, three years wasn't a long time to wait, given the scale of the whopping bull market that followed. But I suspect that any die-hard contrarian who bought US equities on the day that cover was published, probably spent the next three years if not more - feeling very jumpy indeed.

You're asking the wrong question

When will the bond bubble burst? I don't know, is the short answer. But here's a question I can answer.

Are bonds expensive? Yes, beyond a shadow of a doubt. And that's what really matters.

Yields have never been this low in history. So for you to believe that this state of affairs can continue in the long term, you have to believe that something very fundamental has changed about the world. Otherwise, they'll revert to the mean.

Sure, you will read many convincing arguments that suggest bonds can stay right where they are. But I'd suggest you read the BusinessWeek article, and look at how convincingly it made the case for equity being dead. One contributor quote in particular stands out: "We have entered a new financial age. The old rules no longer apply."

So let's agree bonds are expensive. What's the oldest rule in investing (or one of them)? Buy low, sell high'.

So avoid expensive stuff. You don't need to be in bonds. You don't manage anyone else's money. So you don't have to fret about impatient clients pulling their money out of your hands if you aren't invested in the latest bubble.

All you have to control is your own impatience. That's easier said than done of course. But at least your job doesn't depend on it.

So what do you buy? You buy cheap stuff, of course.

I know I sound like a stuck record by now, but European stock markets look cheap in historic terms. Despite big rebounds since the summer, the peripheral countries still trade on cyclically-adjusted p/e ratios of below ten. That typically means you'll see very healthy returns within five years. Yes markets can get cheaper but probably not a lot cheaper.

Just for reference when that BusinessWeek cover was published, the CAPE for the S&P 500 was below ten. By 1982 it had fallen even further. But if you'd bought back then, and held for any sensible length of time, you'd have been a very happy bunny.

We discuss the bond bubble among other things - in our latest roundtable, which you can read in this week's issue of MoneyWeek magazine (out tomorrow if you're not already a subscriber, you can subscribe to MoneyWeek magazine). Needless to say, none of our participants had a definitive answer as to when it will burst. But they had plenty of ideas on what you can invest in meanwhile.

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

Follow John on Twitter||Google+ John Stepek

Bangkok's JFK moment

Southeast Asia is attracting a lot of attention from investors - and for good reason, says Lars Henriksson. Here, he explains how to gain exposure to this exciting market.

The French time bomb

Western governments are going bust, as France's slashed credit rating attests. At least investors can profit in the meantime, says Bengt Saelensminde. Here's how.

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.