Bond prices: rocky waters ahead

published 12 September 2007

For the last few years the bond markets have raced ahead, but now they are starting to falter. And the recent falls are just the beginning. The statistics might not show it yet, but inflation is back - and that means the only way for bond prices is down. The corporate bond market has been a splendid place to be invested over the last two years: it produced positive returns of 9.5% last year and more than 14% in 2003 and 2002, says Ivar Simensen in the Financial Times. As companies focused on reducing debt and interest rates hit historic lows, bonds seemed the perfect place for investors' money. But it is beginning to look like the good times might be coming to an end: "March was the worst month for corporate bonds in nearly a year".

Investors, it seems, are being scared off by the threat of rising US interest rates (bond prices fall when interest rates rise), while events such as last month's profit warning at one-time blue chip General Motors (which resulted in the car maker's credit rating being sharply downgraded) haven't helped either. So far this year the return from the corporate bond market has been negative. The yield spread - the yield corporate bond investors demand over the yield on Government debt as compensation for the risks they take - has risen by more than 20% in Europe and the US since the middle of March, something that suggests investors feel risk levels in the market are rising.

So why has market sentiment suddenly changed? For two main reasons, says The Economist. The first is that bonds are "badly mispriced" at the moment. The yields investors are receiving are too low to compensate them for the risks they are taking. "Company balance sheets and cash positions are nowhere near as solid as they were in 1996-1997" - the last time that the difference in yield between (safe) Government bonds and (not so safe) corporate bonds was as low as it is now. The basic point to note here is that most bonds are just too expensive - investors are too complacent about the risks of holding them. As Jupiter corporate bond fund manager John Hamilton, points out in Money Marketing, prices for corporate bonds, especially at the bottom end of the junk market, "have gone up so far that the effective yield no longer adequately compensates for the additional risk of investing. The spread on junk bonds has widened from 4.2% on 16 February to 5% on 21 March." But, says Hamilton, this is just the beginning: "the spread should be 10%-15%" for high-yield bonds once again to look worth buying.

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The second reason for the jitters, says The Economist, is "widespread worry about semi-submerged inflationary pressures". Oil is above $55 a barrel, almost all other commodities are on the rampage too, and in the US the weakening dollar means that the prices of imported goods have been rising fast. Add to these concerns America's requirement to finance its hulking trade and budget deficits, and "both worries converge in a greater one: that higher - perhaps sharply higher - interest rates [are] inevitable". Sharply higher rates would spell the end of both debt-fuelled consumption growth and the rise and rise of illiquid high-yield asset markets, such as residential property, emerging market debt and corporate bonds. In our "over-leveraged global economy", they would also push up the risk levels associated with holding corporate bonds, leading to a gradual but sustained widening of yield spreads in Europe", says Morgan Stanley. No wonder investors are nervous.

One question that has to be asked is, "Why is risk so mispriced?" says The Economist. Bond prices may have fallen a little recently, but they still seem rather higher than they should be. A lot of the responsibility rests on the shoulders of America's central bank, the Federal Reserve. Its decision to cut interest rates sharply in order to prevent recession after the dotcom bubble burst resulted in the market being flooded with liquidity, and its policy of telegraphing its future intentions with regard to interest rates has made it easy for investors to make one-way bets. The Fed has effectively appeared to remove much of the risk from the investing process over the last few years, creating what James Bianco, of Bianco Research, calls "a gigantic moral-hazard". With mainstream returns low, investors have been willing to seek higher yields in risky pastures, in the process making the unspoken assumption that Uncle Alan (Alan Greenspan, the chairman of the Fed) will keep any nasties at bay.

But The Economist acknowledges there is more to the resilience of bond prices than just the actions of the Fed. There is also the fact that all sorts of bond buyers now seem to be driven by considerations other than value.Firstly, there are the foreign central banks, mainly Asian, who buy dollar securities in order to recycle their trade surpluses and thus keep their own currencies competitively low against the dollar (by buying US-denominated assets they support the value of the dollar against their own currencies). And in Britain, there are the pension funds. Sarah Ross, writing in the FT, believes the reason for the UK's inverted yield curve (yields on long-dated bonds are lower than those on short-dated bonds; usually it is the other way around) is not based on economic fundamentals but has to do with the fact "that pension funds have become aggressive buyers of longer-dated gilts, as they have bought these assets as a hedge against their long-term liabilities".

The fact is that regulatory and accounting pressures are changing the way pension funds operate. Once their aim was to be asset managers focused on maximising returns. Today, their core task is liability management: they are focused on almost robotically covering their long-term liabilities. Pension funds in the US have seen similar regulatory meddling and a similar shift of assets into the long-bond market. This may have the effect of matching their assets with liabilities, but it also means the market has been artificially shifted out of kilter, something that can only cause trouble in the medium to long-term.

If you want to know when the trouble will really start, keep an eye on inflation. Many people, says Jonathan Davis in The Independent - such as Michael Hughes, the chief investment officer at Baring Asset Management - think that there is a cycle turn on the way in the US. "Debt as a proportion of GDP," notes Davis, "has grown so strongly in recent years that it is as high as it was at the height of the boom in 1929." To Hughes, that means the turn in the cycle cannot be far away. But if he is right (and on this, he probably is) the big unknown, according to Davis, is whether the process of readjustment back to normal levels of debt will result in a return to inflation, or lead instead to deflation (a period of falling prices). To Hughes, the answer is still unclear. To me, however, it is very clear. The Fed has long been aware of the debilitating effect of deflation on Japan and that is why they cut interest rates so far and so fast. To me, that means that the risks to prices are all on the upside and the risks to bonds all on the downside.

Harold Wilson once said a week was a long time in politics. Well, economics is a supertanker to the windsurfer of politics - it can take months, or even years, for things to turn around. Witness the housing market: MoneyWeek started warning aggressively about it back in May 2004, but only now are prices starting to fall. Likewise, it has been more than a couple of years since a Federal Reserve governor called Ben Bernanke started addressing the perceived risk that the US might go into a deep deflationary spiral. Bernanke was used by Alan Greenspan's Fed to explain the strategy that the US would effectively keep printing money if need be, until any deflation threat had been quashed. Bernanke's reward has just been announced: President Bush has nominated him to be the next chairman of the Council of Economic Advisors. But the real effects of his actions - the return of inflation - have yet to be grasped.

Bond buyers love the prospect of deflation because it means the real value of the principal loan they are owed will go up. As a consequence, they can tolerate a very low-interest income, so Treasury prices rise and bond yields fall. However, any central bank threatening to create excess money supply through easy credit (which is exactly what the Fed has done) should have Treasury bond investors running for the hills. Why? Because an increase in the quantity (of money) leads to a fall in the price of money. Domestically, this fall in the price of money (compared to everything else) is called inflation; internationally it manifests itself as a declining currency.

The dollar has indeed been falling for two to three years now (despite recent rallies in the last few months), but Treasury bond prices - which should have fallen as a result - have, until recently, remained fairly robust (thanks to the price-insensitive buying just discussed). This in turn has kept US long rates surprisingly low; so low, in fact, that the US yield curve is flattening sharply (long-term yields are not much higher than short-term yields). This is important because, according to John Mauldin writing on Dailyreckoning.com, of 20 possible predictors of recession, "the only indicator that was significantly reliable was the inverted-yield curve". "Every time we have had a period of negative-yield curves," adds Mauldin, "we have had a recession within a year." (Yet another thing that doesn't bode well for the UK.)

Yet even as the risk of recession looms, we are seeing rising prices throughout the US. Commodity prices of the likes of gold and oil have been grabbing the headlines, but house prices have also been strong. Manhattan apartment prices, for example, have leapt 23% in the last quarter alone. Another area with runaway prices is Medicare. The Washington Post's Ceci Connolly reports that "monthly premiums for America's seniors will rise to $89.20 in 2006", which amounts to a 34% increase in two years. Medicare payments to physicians jumped 15% last year and this is putting strain on the system: even with the big hikes forecast in premiums, the Medicare trustees' report warned "Medicare's financial outlook has deteriorated dramatically over the past five years and is now much worse than Social Security's". Expect prices to rise more.

The fact is that as the economic cycle runs out of steam on both sides of the Atlantic, both governments, who should be running big healthy surpluses, are actually running large deficits. Bond markets are wary that increased taxation to cover these deficits could well exacerbate a house-price triggered consumption slowdown, a slowdown that has already begun here in the UK. Meanwhile, inflationary pressures mount, threatening price increases at exactly the stage of the cycle when we really don't need them - the start of the downturn. Might that mean a return to the nightmare situation of the 1970s - a bad economy made worse by inflation or stagflation? Inflation has been declared dead long before now, and the statistics are helpfully manipulated to make sure it stays dead.

In the UK, the new inflation statistics (RPIX and more recently CPI) are designed to leave out rising prices from the likes of housing and stealth taxes. The US employs a more insidious price dampner in its statistics - hedonic pricing - which assumes falling prices in various markets, even if prices are not falling. If, for example, you pay the same amount for a new computer every year, the statistics measure that as a large fall in price because there's more computing power inside a computer every year.

The politicising of the statistical measure of inflation - hard enough at the best of times - means that Anglo Saxons on both sides of the pond have grown unaccustomed to anything but the smallest inflationary numbers (though I think we're all aware the cost of living seems so much higher now than it did ten years ago). That means that when inflation does rear its ugly head, there will be the added negative of the shock value. Right now, early warnings such as factory input prices (+10.7% in the UK in February) and public-sector wage rises (+4.7% in 2004) are at the very least flashing orange, if not red, and the trends have been resolutely up for a whole year now. Pressures are clearly starting to build.

In my view, history will show that the market peaked as far back as 2003. Ever since then, yields have been rising in a traditional late-cycle way to discount late-cycle inflationary pressures. The only strange thing has been the rally that started early last year, but that was driven by Asian central banks, regulatory impulsion and carry trade arbitrage. Behind all that there is a lurking menace threatening the holders of all types of bond (corporate and Government) and that is the rising risk of resurgent inflation. You might not be able to see it in the numbers, but it is there.

James Ferguson qualified with an MA (Hons) in economics from Edinburgh University in 1985. For the last 21 years he has had a high-powered career in institutional stock broking, specialising in equities, working for Nomura, Robert Fleming, SBC Warburg, Dresdner Kleinwort Wasserstein and Mitsubishi Securities.