We are on the brink of a bond market collapse

The era of bonds outperforming the market could soon be at an end. But the transition to stocks could be anything but smooth.

Bonds have done incredibly well as an investment in recent decades. But the era of bond-market outperformance could soon be at an end. According to Michael Hartnett of Bank of America Merrill Lynch, 2013 will be a "year of transition". The "recent leadership of fixed income and scarce growth will give way to the new leadership of equities and value stocks".

In the last seven years, $800bn poured into bond funds, while $600bn was redeemed from long-only equity funds, notes Hartnett. However, the smart money' is already switching out of fixed income and back into shares. In the early weeks of January, $35bn flowed back into equity funds.

But this Great Rotation' won't necessarily be a smooth one. One of the greatest risks facing the world economy, warns Allister Heath in City AM, is a wholesale crash in government bond markets. Yields on UK government bonds (gilts) are too low, and capital values are too high (bond yields fall as prices rise).

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The sheer size of government-bond markets, and the fact that many banks, insurers and pension funds are large holders of these assets, "will trigger wealth destruction on a massive scale" if prices fall, he says.

Indeed, by keeping interest rates so low for so long, central bankers may have created a "ticking time-bomb" for unwary bond investors, says The Wall Street Journal. Losses could quickly escalate. After the first ten days of January the Bank of England was already sitting on mark-to-market losses of £7bn on bonds held under its £375bn quantitative-easing programme, "wiping out a good chunk of its paper profit", according to Bank of America Merrill Lynch estimates.

If and when a lasting rotation occurs, the best-case scenario would be a repeat of the 1960s, when both equity and bond yields "rose in an orderly fashion", says Hartnett. But there are two obvious risks: a repeat of the 1994 bond crash, or the 1987 stockmarket crash, driven by a currency war.

To head off inflation, in 1994 Federal Reserve governor Alan Greenspan raised American interest rates from 3% to 3.25%. The unexpected hike triggered a sharp sell-off in bonds as prices slumped and yields soared. In 1987, rising bond yields coincided with currency devaluation by major economies, unnerving investors across the globe.

That all sounds bad enough, but a shift in market sentiment now, triggered by either an economic recovery or a loss of confidence in central bankers' ability to control inflation, could "inflict more pain than in the past", warns The Wall Street Journal. Money has flowed into bonds at an extraordinary rate, making the stakes higher. And low yields have made bond prices extra sensitive to any movement in yield.

Bonds might not be the only vulnerable asset class, says Heath. In 1994, other risk assets were also heavily sold off. The Bank of America Merrill Lynch emerging-market debt index fell 15.33%, while the MSCI emerging-market equity index dropped 8.67%. So investors hoping for bumper equity returns may be disappointed.

While research from Credit Suisse shows that the real (post-inflation) value of British equities, with dividends reinvested, grew by a factor of 316 over the last 113 years, compared to just 5.5 for bonds, "nobody has a 113-year investment horizon", says Heath. The high equity returns in the second half of the 20th century were abnormal. So "those who believe that it is easy to forecast which assets will turn out to be safe havens amid the inevitable carnage are clearly deluded".

What's more, as the Buttonwood columnist says in The Economist, if central bankers miscalculate and rapid inflation ensues, it could hurt both stock and bond markets. In the inflationary 1970s, US share prices fell by a third. As Hartnett notes, one of the few ways to hedge against such a risk is to hold gold.