Are We Looking At A Bond Bubble?

Interest-rates-1790-2012My Comments: There are just as many ways to lose money with bonds as there are with stocks. The risk is different; what happens to interest rates in the future vs corporate earnings and their relative size. That’s an oversimplification but you get the idea.

The chart above shows interest rates from 1790 – 2012. You can draw your own conclusions about where they are likely to go next. It won’t surprise anyone if it happens this year or three years from now, but happen it will. And yes, I’m sensitive to the length of the horizontal axis.

When it does, you need to be positioned to not only avoid losses, but to potentially make money. It can be done and smart people will make money. Who you talk with and when you act is up to you.

By Gillian Tett / March 13, 2014 / The Financial Times

The more money that floods into fixed income, the more risky any reversal

Seth Klarman, the publicity-shy manager of the $27bn Baupost hedge fund, has given investors a slap. In his quarterly investment letter, he declared capital markets are in the grip of a wild bubble.

“Any year in which the S&P jumps 32 per cent and the Nasdaq 40 per cent while corporate earnings barely increase should be a cause for concern,” he wrote, pointing to “bubbles” in bond and credit markets, and “nosebleed stock market valuations of fashionable companies like Netflix and Tesla”.

It might sound reminiscent of 1999, when “fashionable” technology stocks last soared on this scale. But there is a twist: today it is not equities but bond markets that may yet be the most significant cause of concern.

In recent years an astonishing amount of money has quietly flooded into fixed income funds, which buy corporate bonds, emerging markets bonds and mortgage debt. And as the US looks more likely to raise interest rates, creating potential losses for bondholders, the flows could reverse – creating destabilising shocks for regulators and investors alike.

Consider the numbers. Just after Mr Klarman issued his warnings, the investment research group Morningstar produced analysis that suggests US investors have put $700bn of new money into the most mainstream taxable US bond funds since 2009. Since bond prices have risen, too, the value of these funds has doubled to $2tn. That is striking. But more notable is that these inflows to fixed income have outstripped the inflows to equity funds during the 1990s tech bubble – in both absolute and relative terms.

Meanwhile, Goldman Sachs estimates (using slightly different forms of calculation) that $1.2tn has flowed into global bond funds since 2009, compared with a mere $132bn into equities. And a new paper from the Chicago Booth business school estimates that inflows to global fixed income funds have been almost $2tn since 2008, four times that of equity funds.

Given this, it is no surprise that investment grade companies have been rushing to sell bonds at rock-bottom yields (this week General Electric, Coca-Cola and Viacom were just the latest). Nor is it surprising that junk bond issuance hit a record last year; or that Moody’s, the US credit rating agency, warned this week that investors are so desperate to gobble up bonds that they are buying instruments with fewer legal protections than ever before.

But the $2tn question is what might happen if, or when, those flows change course. Until recently it was often presumed that corporate bond investors were a less skittish group than equity investors; fixed income funds were not prone to quite such wild sentiment swings.
However, the four economists who penned the Chicago Booth paper argue that this is no longer the case.

Analysing market data since 2008, they conclude bond market investors have an increasing tendency towards volatile swings and herd behaviour. That is partly because of fears that the US Federal Reserve could soon raise rates. But the sociology of asset managers is crucial, too.

“Delegated investors such as fund managers are concerned with relative performance compared to their peers [because] it affects their asset-gathering capabilities,” they note. “Investing agents are averse to being the last one into a trade [which] can potentially set off a race among investors to join a sell-off in a race to avoid being left behind.” And while such behaviour can affect all fund managers, the Chicago analysis suggests bond fund managers have recently become much more skittish than their equity counterparts.

One sign of this occurred last year when bond markets, fearing the Fed was about to tighten monetary policy, had a “taper tantrum”, the Chicago Booth authors say. They warn that “bond markets could experience another tantrum” when the “extraordinary monetary accommodation in the US is withdrawn”. And since it is now the bond funds, not banks, that hold the lion’s share of corporate bonds, if another taper tantrum does take hold that could be very destabilising.

Today, as in 1999, nobody knows when that turning point might come. But the more money that floods into fixed income, the more dangerous any reversal could be. Investors and policy makers alike need to heed the message from the Chicago paper – or from Mr Klarman. History may not repeat itself; but, when bubbles occur, it does have a tendency to rhyme.

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