Are Bonds Still a Safe Investment, ‘Bond Bubble’ Coming Soon?

Economic BubbleBond prices have been defining the last decade of market returns as they continually escalate in an uncertain environment. While the continuing demand for ‘risk-free’ assets would be considered an essential part of the accepted market portfolio, the progression of bond markets since the 1980’s have created a situation that seems to be leading towards an event that analysts are referring to as a large scale ‘bond reversal’.

Specifically, the 8x rise that bonds have experienced over the last 20 years suggests the presence of a pricing bubble that is getting ready for collapse. That being said, because of the way these debts are generally tied to robust national economies or AAA rated corporations, we need to dig deeper into the details to understand exactly how it is that the bond trend is playing out before we can start to make any assumptions about a reversal trend.

Bond return trends can be examined from two perspectives. For starters, we can take a look at how it is that US Treasury bonds have been on their greatest historical bull-run ever recorded, resulting in a situation where yields are at all-time low points. Despite the low rate of return, investors are still showing a desire to buy up new issuances because of the way in which the bills protect their assets against stock-market volatility, even though their value is further reduced against the US’s currently aggressive inflation policy.

However, what’s interesting about this trend is that investors are also consuming record amounts of Gold (despite recent volatility), suggesting that investors are looking to hedge both inflation and deflation at the same time. This essentially means that investors are concerned more about volatility than they are the market’s actual direction, and are therefore trying to protect themselves from uncertainty beyond anything else. The rise in treasury prices can therefore be seen as a trend of protectionism that would need to reverse when either concerns surrounding the Federal Reserve’s involvement in the economy end, or when the risk of default materializes on the US’s federal balance sheet.

After looking at treasury bonds as a volatility hedge, we can start to delve into the sophisticated world of high yield (junk) bonds, and how it is that they add a whole new level of complexity to the emerging debt-bubble. Traditionally, high-yield bonds have traded along-side equity securities as a substitute for yield, but with a lower return volatility (and therefore a lower expected return against that of the paired equity security). However, as of 2009 we can start to see a trend where junk bond prices began to out-perform their respective equity securities as investors began to reduce their exposure to volatility in exchange for yield returns.

This trend eventually became self-perpetuating in the way that it created capital gains returns for debt investors, and allowed them an opportunity to re-invest at better rates than what the market was providing. However, as the junk bond markets grow, so does the volume of money lost in a default event. Investors are therefore pricing their portfolios in an ‘all-or-nothing’ fashion that will either return a high-yield return, or a complete default from insolvency.

So how do we put all of this information together to come to a conclusion? We simply follow the trends. While risk free assets are already taking real-losses against inflation, high-yield (risky) assets are approaching the point at which they will soon be breaking even against inflation, even though they represent a risk that is well beyond that level of return. Worse yet, as corporate bonds reach yields closer and closer to that of their equities, they will become a value-paradox.

The end result is a situation where the fundamental pricing of debt against relevant equity securities will strongly encourage investors to move their assets over into the stock markets (despite the higher volatility and perceived risks) because of the way in which the sheer yield implications favor the transaction. Whether it be then a result of declining perceived volatility, or yield rates crossing, the implications for an asset rotation have never been stronger.

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