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Is the bond bubble about to burst?

19 January 2015, VEB

Written by Victor Zwart

A great deal has been written again in recent months about euro-denominated bonds. The reason for this is that the price of these bonds has gone up (risen) sharply as a result of interest rates that continue to fall in the euro zone.

Because prices have already been climbing for two years, some people have started talking about a bubble. And as you know, bubbles can ‘burst’. Which is why it is of interest to know whether this really is a bubble and, if so, whether it is about to burst.

Over the past two to three years, corporate bonds have been in high demand because the returns from government bonds have been so low that investors have opted en masse for corporate bonds delivering higher returns.

The fact that savings accounts are also generating practically nothing has definitely contributed to this trend. As a result of the quest for return, there has been above-average demand from investors and (fund) managers for corporate bonds, which in turn has driven their price up considerably.

A second category of debt instrument very much in demand is high-yield bonds. These bonds were previously called junk bonds, but commercially speaking ‘junk’ doesn’t sound too good and so issuer prefer not to use the term for this category of bonds, which have a credit rating lower than BBB.

Because these bonds have a low (or no) credit rating, they usually produce a higher return. This means that just like the bonds mentioned above, this form of investment has become enormously popular among investors and (fund) managers in recent years.

Unfortunately, people often overlook the fact that the higher return is only offered to offset the (substantially) higher underlying risk associated with these bonds. If the return on offer is too low, then no one will buy the high-yield. It’s a question of risk and return.

But the prospect of a good return makes many investors forget the risk – such as those who invested in the types of investment previously being offered (and probably still being offered) by managers with no track record or demonstrable knowledge of any kind, but who kept promising a consistently above-average return to the investor. Greed is good...but too much of it might turn out to be disastrous.

My answer to the first question is that prices for practically all forms of bond have risen significantly, as a result of which, de facto, you could say that there is a bond bubble in the offing.

The second elementary question now, though, is whether or not that bubble is about to burst. A bubble – just like an air bubble or soap bubble – can pop at any time because there is no foundation for its existence. To allow the bubble hypothesised above to burst, there would have to be the expectation (by investors) of a rapidly rising interest rate in the euro zone.

Based on this expectation, investors would then sell their bonds en masse so that they wouldn’t see their price gains evaporate. As a result of this wave of selling, bond prices would then fall back significantly: i.e. the bubble would ‘burst’. But based on the economic outlook, this scenario is still unlikely in the euro zone for the months ahead.

Economic growth is very low and the outlook is barely any better. Inflation is still falling (at the end of November 2014, inflation was 0.3% for the euro zone as a whole and 5 European member states are currently already experiencing deflation) and it is unlikely that it will rise significantly as long as economic growth fails to materialise, salaries remain stable and commodities (including oil) continue to fall.

A ‘Grexit' (Greece leaving the euro) could well distort this picture for a while, but then fundamental economic developments would restore the picture again.

So, to conclude, you could say that there is a bubble in terms of bond prices, but the chances of it bursting in the short term remain low for the time being. Nevertheless, because unforeseen developments could cause circumstances to change, I advise you to remain vigilant with any type of bond. Investors would do well to start looking closely at the way to make a profit from falling bond prices. There are plenty of opportunities.

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