Who’s afraid of the big bad bond bubble?

By Susan September 12, 2012 08:37

Who’s afraid of the big bad bond bubble?



Have you been enjoying the recent articles about bonds? If they sparked your interest, perhaps you are following trends in the bond market with a keener eye now…


And you might have heard of an ominous “bond bubble”, worrying that just when you were considering investing in bonds, there had to be a bubble!


The bond bubble is a big concern for investors at the moment and has been sparking quite a lot of comments and analyses. But really, is the bond bubble such a big deal?


In this article I take a look at why the bond bubble came about, what the consequences would be if it burst, and what this means in the context of the Maltese economy – since the situation in Malta is in contrast with other markets. And as you know I keep Malta firmly on my radar!



Are we really experiencing a bond bubble?


A bubble, in financial market speak, is “an irrational psychological market environment resulting in extreme disequilibrium and some form of systemic collapse”. If this bubble was to burst, it would have catastrophic effects and we would witness the same kind of extreme disequilibrium that we witnessed in stock markets in 2008.


Or would we?


I would like to examine the assumptions on which this forecast is based. Now why do we think that there is a bond bubble in the first place?


Prices on the bond market have been rising significantly, which is something you would expect in a bubble. This is correlated with decreasing interest rates: these rates have been steadily declining since the 1990s, and lately they have seen an absolute collapse as central banks try to stimulate the economy.


A few years back, bond prices were low and yields were higher. Fastforward to the stock market crash, and investors are not looking for yield anymore – they are happy to simply protect, as opposed to grow, their money. And indeed, with high prices, bonds now offer little yield.


This has come to the point that these investments are now offering negative yields. The normal mechanism would of course be the opposite, the borrower rewarding the investor lending them money with a return for the risk they are taking. Having to, in essence, pay to let somebody benefit from a loan of your money sounds completely wrong: banks don’t pay their customers to give them a mortgage, quite the opposite! This could be the irrational market environment typical of a bubble about to burst.



What is the worst that could happen?


Were this bubble to burst, what is the worst that could happen in a context where prices can’t go any higher and investments mostly offer negative yields? The bubble bursting means prices would fall dramatically.


But this wouldn’t affect people holding bonds until maturity: bonds being fixed income, they would still be redeemed at par (unless there is default). What is more, based on figures in the past, a dramatic fall in bond prices would be around 10%. That is nothing like the 70 or 80% dives witnessed by the stock market. So the bond bubble bursting would actually have limited, if painful, impact.



For the bubble to burst, interest rates would have to rise


Now for the bond bubble to burst, prices would have to fall dramatically. And for bond prices to fall, interest rates would have to rise.


But this scenario only begs the question – who can possibly afford interest rates rises? Countries that are deep in debt like Greece, Spain or Italy? This is not a likely scenario at the moment, since the ECB certainly doesn’t want to put in-debt countries in the position of not being able to pay back their debts. So there no real reason for bond prices to fall significantly.



The other side of the coin: inflation


In the context of massive money printing in many countries, it would be easy to argue for considerable inflation in the future. In recent reports, Eurozone inflation was announced to be at 2.4% for the third month in a row. This means that if you had a portfolio to protect and wanted to maintain your purchasing power, 2.4% would be the minimum rate you would accept to invest your money.


If you look at the bond market data on the front page of the FT at the time of writing, you will see that not one government bond is offering a rate even near 2.4%. A 10-year German bond only offers 1.42%, a full percentage point lower than inflation. The best you can get is a 10-year US bond at 1.67%, but that is still 73 basis points away.



Malta is doing well, but for how much longer?


Now in complete contrast to the main markets, the long term interest rate of Maltese government bonds is 4.15%, while inflation expectations in Malta are around 2.2%. And the Maltese government’s ability to repay is significant, allaying any default worries investors might have. In other words, with Maltese government bonds offering twice the level of inflation, does this mean that Malta is immune to the bond bubble?


That is very satisfactory for now, but how about the future? How likely is it that inflation will be maintained at that level?


Malta is a tiny, if growing, influential part of the Eurozone. Even still, its inflation rate is unlikely to have much of an impact on interest rates – contrary to, for example, German inflation. Malta is enjoying the fastest employment and wage growth rate in Europe: both feed into higher inflation in the future.


The problem is that decisions regarding Malta’s monetary policy tools are not down to the Maltese government but to the Eurozone.


Another interesting insight comes from the balance of payments: 70% of Malta’s exports go to 9 Eurozone countries, which would benefit from the weakening Euro, while 60% of its imports come from outside the Eurozone. If the euro were to weaken further, this would have a significant impact on the Maltese inflation rate. And that is totally outside of the Maltese government’s control – they are at the mercy of what the Eurozone does. Unlike Ireland, that exports far more than it imports, and so is delighted with a weakening euro, Malta has a very tight balance of trade.


At the moment, Malta is at odds with the rest of the world, and in a very good way, in terms of their bond rate, which is much higher than their inflation rate. That seems likely to persist and has been stable over the last year. But the signs are clear that in the immediate and medium term, there will be upwards pressure on inflation and this is something that the powers that be need to be proactive about.


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By Susan September 12, 2012 08:37