‘Bond bubble’ an over-generalisation

These articles often employ the natural extension that investors should switch from bonds to equities.

But is there a bubble? Does this mean it’s a good time to buy equities? What are the alternatives?

As with many sweeping statements, the bond bubble is an over-generalisation of a multi-faceted market.

Government bonds in many western countries are at record high prices, driven high by risk aversion and quantitative easing (QE). Ten-year government bonds are now yielding less than 2 per cent in the UK, US and Germany. Corporate bonds from low-risk big corporations that trade at small margins above government bonds are similarly now offering returns to maturity that, after fees and inflation, are close to zero or even negative.

Most western governments are desperate to keep their economies growing in order to reduce unemployment and maintain some level of inflation that slowly reduces their indebtedness. With base interest rates close to zero and without the ability to lower taxes, keeping long term rates low through quantitative easing (QE) is seen as the next best stimulus.

Do not expect government bond yields to start rising until higher growth levels are generated and look sustainable. This could be some time yet in Europe. In the US the Fed says that they will continue easing until at least 2014.

In Japan the turnaround never really happened. When Japan’s asset price bubble burst in 1991 it took 11 years for long term bond rates to fall below 1 per cent in 2003, where they remain.

While we continue with these very low cash and government rates there are corporate bonds available, both in the new issue market and in the secondary market, where returns can be above inflation after fees.

These higher yielding bonds, as well as paying a positive real return, can provide a cushion against the first tick-up in interest rates as and when it happens. However, investors have to be very selective to find these bonds and be wary of taking on unnecessary risk.

The issuing companies must have both the ability and willingness to pay. In this tough business environment this often means household names with good cashflow, strong brands and a reputation with the bond market that they would not want to tarnish.

Having flushed these out investors can then look for the better value higher yield bonds. In essence what to look for is the riskiest bonds from the safest companies.

Buying equities just because you do not like the returns from fixed income is a dangerous move. Equity markets could similarly be artificially high because cash and government yields are so low.

James Baxter is managing partner at Tideway Investment Partners