There is lots of talk at the moment about the bond bubble, sparked by the volume of flows into government and corporate bonds as investors shun equities for fear of their volatility increasing and values falling.
Bubble and strife
According to Aquila Capital, European investors are overwhelmingly planning to stick to government bonds in the next 12 months even though half of them think over the next five years they will get a negative return. One-fifth of the 255 institutional investors surveyed even said they will increase their allocation to government bonds in the next year.
Roland Schulz, managing director at Aquila Capital, concluded: "With the changing risk profile of bond investments, investors are increasingly moving towards alternative investments in particular real assets, equities and absolute return.”
So is there madness in investors’ methods or is continued interest in bonds, gilts in particular, nothing short of foolhardy?
According to Robert Froehlich, senior managing director of the Hartford Financial Services Group (as quoted in MoneyWeek): "The bond market is a bubble and it’s getting ready to burst."
The same, though slightly more forceful, opinion was given to today’s FT when Arthur Steinmetz, chief investment officer at Oppenheimer Funds, commented: “People, out of fear, are getting poor slowly. I’d like to dump a bucket of cold water on these people and say ‘think about it!’ Consider the consequences of your choice’.”
Ten-year gilts and treasuries are only paying out 1.75%. Inflation in the UK is 2.7% and set to rise through the 3% mark in the next couple of months, and US core inflation is 2.2% though it is expected to drop marginally.
The conclusion is obvious – If you buy government bonds today you are guaranteed to lose money.
The problem is where investors should go to instead.
Little competition
Kleinwort Benson’s chief investment officer Mouhammed Choukeir admits that most people seem convinced the bond market is in a bubble, but adds: “Such negative sentiment suggests an overly bearish view on the asset class. We like to use sentiment as a contrarian indicator, so we view such pessimism as an opportunity. In 2011, most investors had a negative bubble view on bonds – that sentiment was wrong.”
The key for him – and plenty of others – is bonds’ ability to preserve wealth far better than equities that have no guarantee whatsoever of future returns or capital protection.
He said: “Our research shows that during the 15 worst performing quarters for equities since 1871 (therefore including the big bond bear market from 1950 to 1981 and the big bond bull market from 1981 to 2007), government bonds preserved wealth or rose 14 times. Therefore, at the extremes, bonds diversify equity risk – even during bond bear markets.”
So, while bonds do have risks, as long as the outlook for interest rates and inflation remains low, and as long as investor sentiment remains on the negative side, fundamentals go out of the window and gilts will continue to trump equities.
The answer to the conundrum is that there is a bond bubble but it is not going to burst just yet.
