Are we in a Bond market bubble?

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Ten years after the financial crisis, very little has been fixed. Governments around the world are carefully trying to reconstruct their economies and treasurers are keeping a close eye on the latest moves around the globe. Strategists are concerned that the bond market may be about to trigger another crisis.

 

While the 2008 crash was sparked by consumer debt and mortgages, the next issue could be corporate debt. Companies correlated to struggling higher levered consumers such as those in health and telecoms could be in trouble.

 

Sovereign bond markets could also trigger a collapse. Quantitative easing in major economies has resulted in bond-trading reaching multi-decade heights. One strong indicator of a potential crisis is that other countries have moved to investing in safer markets such as gold.

 

Even so, bond yields continue to surge, creating anxiety in the equity markets with US equities recently falling to a two year low. That tumble may be a temporary breather, but a closer look confirms the influence of bond yields.

 

Increases

 

In the US, while the S&P 500 fell, yields on ten-year Treasuries climbed to a four year high of 2.84 percent. In Australia, ten-year bond yields were peaking at 2.78% with a 15-year bond nudging 3%.

 

Last year a single buyer bought A$800m of Australian government bonds, the largest amount bought by a lone buyer for 35 years. This highlights how even those in fixed income markets around the world are focused on the possibility of tighter monetary policy and higher bond yields. Small increases in interest rates may prove increasingly interesting to investors.

 

Indicators from emerging markets confirm the upward trend in bond yields, raising the issue of narrowing returns between bonds and equities. The S&P 500 offers annual profits of around 4.3% of the index price and many observers may feel that this is comfortably above treasury rates, which it is by about 1.5%. However, bond yields have narrowed the spread to the smallest gap in the past eight years.

 

Another way of looking at this comparison is that, relative to yields, treasuries currently trading at a multiple equating to approximately 37 times that of the annual interest pay-out, which could be considered their earnings. That is in contrast with 22.6 times profits in the context of the S&P 500. A rise in treasury rates to 4.3% would even the ratios, and that is what makes alarm bells ring.

 

Treasurers

 

While concentrating on the Fed model may not suit all treasurers, the power of the US economy and how it influences debt capital markets around the world cannot be overestimated.

 

While treasurers may argue that corporate earnings and bond yields are not the same and move with different sensitivity and volatility to other economic indicators such as inflation, the comparison is usually a background factor for investors when they consider the staying power associated with a bull market, especially one which has lasted for so long.

 

Even equity analysts accept that if bond yields increase, the associated rewards are greater. At the margin, the buyer or asset owner is tempted by the security offered by bonds and enticed to put more into fixed income than the equity market.

 

With economic indicators suggesting that central banks are not averse to increasing interest rates, this is something else which may influence the view of the bond market. Higher interest rates make stocks look expensive, especially relative to a fixed-income alternative. As yields on bonds rise, investors flee to that perceived safe-haven, especially since equity valuations are at historic high levels, potentially spooking the market with some expectation of adjustment.

 

Although optimism over share prices, corporate earnings growth and a general economic feel-good factor may outweigh rising bond yields, especially when they remain low on an historic basis, the move towards bonds is a concern for analysts. One of the main reasons for this is that there is no mechanical link between treasuries, corporate bonds and the stock market.

 

One strong indicator as to where bonds are going are rising 10-year rates. These are a bullish signal for the economies around the world, demand for money is rising and companies want to put theirs to use. The expectations for long-term growth are seen in the widening gap between two and ten-year yields which has grown recently. By comparison, the holy grail of long-term growth even in a stock bull market looks as unattainable as ever.

 

The rising interest in bonds is taking its toll on equities and it is government economic policy which is likely to dictate whether the bubble will finally burst.

 

Simon Lynch is the owner of Treasury Talent.

Treasury Talent is a specialist treasury talent provider solely focussed on the treasury market with offices in Sydney covering Australia, Singapore covering Asia, and San Francisco covering California and the USA. To make contact simon@treasurytalent.net

 

 

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