Investors should wise up on bonds

Ever since developed world governments took on a mountain of debt to bail out the financial system in 2008 and 2009, investors have predicted the end would be nigh for their debt.

The initial perception in 2009 was that the US and the UK governments –according to the European narrative, the Anglo-Saxon economies at the heart of the crisis of capitalism – that would fare the worst. As they were creating money and using it to buy government bonds – through quantitative easing – the perception was they were artificially propping up their debt market, in a manner that would prove unsustainable once inflation kicked in.

It was in the peripheral eurozone countries, however, that a government bond bubble burst, starting in 2010. In the case of stronger eurozone economies – eventually only Germany – and all other developed world authorities, government bonds kept rising and their yields kept falling.

Investors started observing that peripheral eurozone economies had the opposite problem to the one originally forecast – that eurozone authorities were not doing enough to support their member states’ finances. Moreover, the eurozone periphery remained very much the exception. The debt of other developed world governments with their own currencies performed well.

One key reason investors blackballed quantitative easing was it would prove unsustainable once inflation set in, knocking out the debt markets’ key crutch from under them. This again proved to be a mistake. Following higher inflation the Federal Reserve held off on quantitative easing in 2011 – as did the Bank of England for much of it – and US government bond markets still soared. Many investors marvelled at the fact that buyers were tolerating a yield on government bonds that was lower than inflation and took it as further evidence of a bubble.

There is, however, a different way of looking at government bonds – as an alternative to cash. If interest rates are close to zero, suddenly anything yielding more than 1 per cent looks attractive – let alone 2 per cent, which investors last year regarded as a dangerous yield for US government bonds maturing in 10 years. Of course, some investors would point out that over 10 years lenders risk losing part of their capital at these levels, which is not typically a danger with cash. But if investors are predicting a lost decade for the developed world – reasonably, in view of the future that awaited Japan 10 years ago – then even yields below 1 per cent might be sustainable.

But now investors are grasping this point – this time in government bonds’ favour – they may again be mistaken. Barring the wholesale collapse of institutions and deposit insurance schemes, losing money on conservatively managed cash is almost inconceivable – unlike the capital value of government bonds, which is at the mercy of market sentiment. With the exception of the eurozone, investors’ original reservations about government bonds were wrong at the time. That does not mean to say they should abandon them now.