The global hunt for yield has translated into a voracious appetite for bonds that has been piqued by investors' aversion to risk. Put together, these components of yield hunger and risk aversion have led to huge demand for government bonds. This has produced some interesting outcomes in recent times, including the South African rand's exceptional performance that looks like it will extend to take the currency into "six-rand-to-the-dollar" territory before the rand heads for "eight" territory. However, why speculate on the direction of a flighty emerging market currency when there a much bigger story that has developed, namely the sovereign bond market bubble?

In the note below, Jeremy Siegel tackles this topic, and suggests that investors in these so-called "risk-free assets" are taking on a lot of risk by putting themselves in a position that comes with a high probability (my word) of capital loss.

As always, the arguments presented by bond bulls are familiar to us and include:

  1. the asset class has superb attributes, such as being "risk free" which means you cannot lose money by investing in government bonds (imagine that - a guarantee on capital and a guarantee on return);
  2. yields are compelling because inflation will stay low or go even lower. This implies the economic environment stays stable and there are gains to be hide despite the huge gains already seen; and
  3. If things change, bond holders will be able to clear out in time to avoid a calamitous drop in bond prices (with the pundits forgetting that when this does happen you can only sell your bond portfolio when buyers appear at a price set by the buyers).

In short, it looks like the "A-rated" asset of bull market bonds are heading into the "Triple B" territory of a "bull bond bubble".

Bond Risks And How To Beat Them by Jeremy J. Siegel

Friday, September 17, 2010

The op-ed piece The Great American Bond Bubble that I published on August 18 in The Wall Street Journal with Jeremy Schwartz, Director of Research at WisdomTree Investments, attracted both attention and controversy. That is what we wanted. We claimed that, at today's prices, investors in government bonds would regret their purchases just as investors in stocks did at the top of the technology bubble a decade earlier. At the height of that bubble, investors paid an unprecedented one hundred and more times earnings for large companies, a price that was bound to disappoint. Today's investors are paying 100 or more times the one-year's return on a 10-year TIPS (Treasury Inflation-Protected Security), a price which we also believe will lead to substantial losses.

We also believe that investors have some serious misconceptions about bond funds they are clamoring to buy. Many assert that Treasury bond funds are safe because the principal and coupons are guaranteed by the US Treasury. Furthermore, although they concede that interest rates will rise eventually, they believe they will have time to get out of their bond funds before prices drop significantly. These misconceptions will cost these investors a pretty penny.


Many critics objected to our analogy between high-flying tech stocks and treasury securities. Stocks, of course, have no guaranteed return, while the U.S. government guarantees both coupons and principal of Treasury bonds. This guarantee means that an investor who holds his bonds to maturity will always receive a specified dollar return, quite unlike a stock investor.

But the words "hold to maturity" are critical. Investors are piling into funds that do not hold these bonds until maturity. Funds sell bonds nearing maturity and replace them with similar bonds of longer maturity. That means that if interest rates rise, these bondholders will take a permanent loss on their portfolio.

Interest rates do not have to rise much for Treasury bond investors to realize substantial losses. If, over the next year, interest rates on the 10-year Treasury rise to a level reached last April of 3.99%, the return on the bond is negative 9% (including interest paid). If rates rise to 5.30%, the level reached before the financial crisis, the loss will double to 18%. If the 10-year interest rate rises to the record postwar level of 15.84%, the loss will be 73%, far worse than any bear market in stocks (including the last one) since the Great Depression. All these are computed from the 2.47% rate reached by the 10-year Treasury on August 31.

The potential losses on 30-year Treasury bonds, which are often used to fund IRAs and 401(k) accounts, are much worse. If the 30-year treasury yield, which ended August at 3.52%, returns to its April high, bondholders will suffer a loss of 17%. If yields reach the average level it has been over the past 30 years of 7.3%, the bondholder will experience a price a decline of 50%, equal in magnitude to the worst bear markets in stocks in the past 50 years. For those investing in bond funds, these losses will never be recovered unless interest rates return to current levels.


Several analysts did not think current long-term rates were unusually low. Tony Crescenzi, a market strategist and portfolio manager from Pimco, noted that, if inflation runs at about 0.5% over the next 12 months, as they forecast, the real yield on 10-year treasuries will be just about 2%, in line with their historical estimates.

But you cannot calculate the real yield on a 10-year bond from forecasting the inflation rate over the next 12 months. One must take the expected rate of inflation over the next 10 years into account. Our economic recovery may now be on hold, but it will not be delayed forever. When economic growth resumes, it is quite likely the Fed will err on the side of higher -- not lower -- inflation.

I personally believe the average 10-year inflation will be between 2% and 4%. If so, the rate on Treasury bonds will increase to 4% to 6% and will impose severe losses on today's bond holders. And there will be no warning bell sounded when it is time to exit the bond market.


Bond enthusiasts claim that, since the Fed has insisted that it will maintain low short-term rates for an "extended period" there will be plenty of time to sell bonds before interest rates rise.

Oh, were it only so easy! Traders in Treasury bonds do not wait for Fed announcements. Well before the Federal Reserve raises the Federal funds rate, long-term interest rates will have risen and the price of Treasury bonds will be down. In fact, if we get a string of even moderately strong economic news over the remainder of this year, we will see the 10-year Treasury yield well above 3% by December, imposing substantial losses on current bondholders.


Given the extraordinary low interest rates on bonds, I believe that stocks with earnings that comfortably cover their dividends will be the best investment. Currently many large U.S. and international firms fit that bill. The 10 largest US dividend payers -- AT&T, Exxon Mobil, Chevron, Procter & Gamble, Johnson & Johnson, Verizon Communications, Phillip Morris International, Pfizer, General Electric, and Merck -- sport an average dividend yield of 4%, approximately three percentage points above the current yield on 10-year TIPS and one and one-half percentage points ahead of the yield on standard 10-year Treasury bonds. Their average price-earnings ratio, based on 2010 estimated earnings, is 11.7, versus 13 for the S&P 500 Index. And their earnings cover their expected dividends by a ratio of more than two to one.

In all the debate about whether or not there is a "bond bubble" no one questioned the wisdom of adding high dividend-paying stocks to investors' portfolios. And that was the most important message of our article.