If you are in any way tuned in to financial market, you can’t fail to have noticed that the fashionable talk is of a bond “bubble” about to burst. Conventional wisdom holds that investors should favour supposedly low-risk bonds and reduce riskier shares as we get older.
So how do bonds work and why is this so important for markets? Bonds are IOUs issued to investors by governments and companies eager to expand. Investors buy them to be repaid the original capital value at a set date, plus interest. However, bonds can be bought and sold before maturity at the set date and so their prices are subject to market forces.
Interest paid by the bond generally stays the same each year, despite the movement of the price of the bond, so when the price goes up, the yield goes down and vice versa.
Since equity markets collapsed in 2007, under quantitative easing central banks around the world have pumped more than $10 trillion of liquidity into the global financial system, buying up government bonds and so keeping interest rates artificially low.
As a result, bond markets have reached record highs and yields have fallen. Investors have been paying the borrowers to hold their money!
It is apparent this so-called bubble has been developing for some time. So long, in fact, that bonds have outperformed shares for 30 years. That’s a remarkable claim for an investment regarded as a less risky alternative to equities. But bond markets can turn rapidly. It happened in 1979 and 1994 with devastating effects for investors.
As a result of concerns about debt markets, many experts say a “great rotation” from bonds to equities has begun, with equities rallying as investors shelter away from bonds in large, well capitalised, dividend-paying companies, which look to be in rude financial health at the moment.
And there is some logic to this. Why buy a bond offering a fixed income of 3.5%, with no prospect of capital growth or protection against inflation when you can invest in the equity of the same company yielding a slightly lower 3%, but offering the potential for both capital and income to grow?
On the bright side, the bubble may not be as serious as it appears. Though bonds look unappealing now, there is an argument the value-agnostic investors (pension funds, insurance companies and banks) will still support the market since regulation demands they match a good proportion of their long-term liabilities at all times.
Also, rising bond yields would raise the cost of government financing, which would harm the recovery.
But credit-fuelled booms (and the following busts) are eventually paid for by higher inflation. Since inflation is likely to be a precursor to a fall in bond markets, this is something investors will be keeping a keen eye on.