As with any asset class, bond valuation is a contentious subject; indeed, many readers will have already balked at the rather controversial strapline. ‘Surely bonds are already in a bubble’ will be a popular, if somewhat myopic, response.
Those citing extreme valuation might reference a bond performance chart, superimpose the price action of tech stocks in the 1990s and consider their work done. The more studious might argue that the ongoing recovery in labour markets, and associated improvements in ‘real/disposable incomes’, puts the consumer back on the front foot, which can keep the global economy in the ascendancy. In an environment where demand picks up, companies are more confident to raise prices and inflation ensues, as does the demise of bonds.
The latter investment case, though less powerful of late, still holds considerable sway; indeed, it is not too much of a departure from our own core thesis. However, to have such a high level of conviction in this view – that it renders bonds in a ‘bubble valuation’ regime – displays a worrying level of overconfidence.
Before going too far down that particular road, let’s revert to the investment classification of a bubble. Sifting through the noise, one could distil the definition of a bubble down to two elements: an extreme valuation versus history; and a greater level of participation (ownership) and/or positive sentiment in an asset versus history.
Taking a look at nominal bond valuations, there can be no doubt the asset class finds itself in an elevated position versus history. Bond yields, which hold an inverse relationship to prices, have fallen in a relatively benign fashion for more than 30 years. The consequence, for a typically prudent investor, is that a price chart looks utterly frightening. However, price cannot be the only determinant in gauging value.
Inflation fluctuation
If we analyse bond yields versus inflation, valuations are not so extraordinary. Inflation is running near zero, leaving 10-year bonds offering a positive real yield (around 1.5% at the time of writing). Of course, inflation will fluctuate, and should it average more than the prevailing 10-year yield then that asset class will make a ‘real’ loss.
What is the probability that inflation ends up averaging more than the current 10-year yield? Based on fundamentals and analysis of history, one would probably conclude it is relatively high. But is it a guarantee? Absolutely not. Indeed, what are the chances that inflation averages zero or worse? Again, based on fundamentals, a best guess is pretty low, but it is far from negligible.
In an environment where long-term interest rates are extremely low, central bank intervention might be losing its effectiveness. This can be observed at several levels. First, additional efforts to take interest rates from 1.5% to 1% cannot have the same impact on demand as having taken bond yields from 4% to 1.5%. In economics parlance, this is known as the law of diminishing marginal utility. To that end, to hedge against a weaker demand and disappointing inflationary outcome, bonds remain a compelling proposition.
Central banks could make policy rates negative and buy long bonds with such force that those rates approach, or go negative too, but this kind of policy shift may end up doing more harm than good. Rates charged on loans are reduced, hurting margins and discouraging banks to extend new credit. Negative interest rates may also encourage savers to withdraw cash from deposit institutions to preserve capital. A diminished pool of savings in the financial sector from which to lend would clearly be a deflationary force.
Regardless if investors remain enthusiastic about the potency of these policy tools, it is still well worth noting how well bonds will have performed if they are deployed.
A thread throughout this article is the uncertainty of economic outcomes. A stabilisation in the oil price would be a tailwind for inflation, as would an ongoing recovery in the labour market. Such a scenario would arrest the need for additional unconventional policy. But what if US shale oil production is not cut as fast as we might expect? Banks may choose to extend funding rather than seize control of an oil asset (otherwise known as ‘extend and pretend’).
Should inventories continue to swell, oil could dip below $20. Again, this is not our base case, but the risk is non-negligible and renders bonds far from bubble valuations.
Participation problem
The other precondition of a bubble formation is a dangerous rise in participation relative to history. There can be no doubt that markets have seen an exponential rise in participation from a specific section of the market; however, this has not come from the more volatile retail sector. Instead, it is central banks that have been the dominant player, as they execute their respective iterations of quantitative easing.
These behemoths are, however, steady hands that are not about to destabilise financial conditions by dumping bonds back onto the market. To that end, despite the outsized purchases from this ‘wakened giant’, there remains no great sense of love for the asset class. The situation remains quite the opposite, with fund managers that are overweight duration among the rarest of breeds.
Based on valuations and sentiment/ownership, it is hard to conclude that bonds have reached bubble valuations. The outlying risk that might just take us there is whether governments remove central bank independence and utilise their policy tools to fund fiscal expansion. Such an approach seems improbable at this stage in the cycle, but it was not that long ago that quantitative easing generated the same response. Central banks do what they must, not what they want.
If this radical policy stance moves more into the mainstream, so inflation expectations might lift off, and with it bond yields. Nevertheless, the likely price action of bonds before such a course correction is undertaken is likely to have be a favourable one.
An additional and equally important point to make is in response to those investors claiming bonds have lost their diversification benefits. Alongside this sweeping, and largely inaccurate, statement is often cited the ‘taper tantrum’ example – a period when bonds and equities sold off as the Federal Governor took a more hawkish stance.
While it is fair to conclude bonds and equities positively correlated over this specific period, the environment was one centred on improving inflation. Should deflation rip through markets, then bonds should continue to prove their worth.
Going further than this, the chart opposite shows the outperformance of bonds versus equities over the 10 most recent negative calendar months. This chart reveals that bonds diversification in nominal terms, during the most challenging of periods, is actually intensifying rather than diminishing.
