Sheep To The Slaughter: Beware The Great Bond Bubble

 |  Includes: LQD, TLT
by: Colin Lokey

They say spotting bubbles is difficult. It isn't. The difficult part is figuring out when they're going to pop and staying solvent long enough to be around to profit from it when they do. With that in mind, let's be honest about something: there is a bubble in the bond market and it is large -- very, very large. According to EPFR global, inflows to bond funds topped $400 billion as of the first week of November; U.S., high yield, and mortgage-backed bond funds have all attracted record amounts of capital in 2012.

Looking back a bit further, investors have dumped $1.1 trillion into bond mutual funds and ETFs since the beginning of 2008. According to Fidelity, that is 33 times more than what has found its way into equity funds over the same period. Last month, Joshua Brown, investment advisor and the charismatic author of The Reformed Broker, had the following message for the investment community:

" lunatics are plowing money into fixed income at all-time low interest rates during the parabolic final phase of a 30-year bond market rally. You are going limit-up long into one of the most obvious blow-off tops in the history of investing".

To be clear, it isn't necessarily the money managers that are the lunatics, it is more likely the uninformed public which has, for the better part of three decades, been taught that investments in fixed income, especially that guaranteed by the full faith and credit of the U.S. government, are 'risk free'. Professionals (some of them at least) know better. Consider the following lament from a bond fund manager quoted by the NY Post's Jonathan Trugman:

"It's my worst nightmare...There's nothing I can do, the checks come in and I have to invest it."

A nightmare indeed. Another manager quoted by Trugman notes that were the yield on the 10-year U.S. Treasury bond to return just to its 10 year average, it would mean principal loses of a half trillion dollars. A 1% rise in rates (which, for reference, is the amount yields on Spanish 10s rose in just one week's time at the end of July) would theoretically wipe out some $35 billion.

This state of affairs -- which can only be described as surreal -- is a consequence of a confluence of factors. Corporate issuance has soared of late as investors embark on a quest for yield amid miniscule returns on highly-rated government debt such as U.S. Treasury bonds and German bunds. August for instance, saw high-yield bond issuance in the U.S. reach nearly $30 billion, more than 4 times the historical average for that month.

On a larger scale, August was the best month on record for global corporate issuance. Indicative of the trend, Moody's reported in October that corporate finance revenue leaped 71% during the third quarter on the strength of what the Wall Street Journal called "...a gushing pipeline of corporate issuance." In the current environment, all investors should become familiar with the following chart which shows the ten year performance of the iShares iBoxx Investment Grade Corporate Bond Fund (NYSEARCA:LQD):

Click to enlarge

Chart: Scottrade

In July -- a record setting month for investment grade corporate bond issuance at $75 billion -- the average interest rate touched an all-time low of 3.2%, less than half the historical average. Since then, rates have fallen even further as the following chart -- which also provides some historical perspective -- shows:

Source: Citi, Datastream

It is virtually certain that rates go up from here, and that means both charts above are going to look substantially different in the coming years. Put simply, if you are buying corporate bonds right now, you are almost guaranteed to lose money. Here's Anders Maxwell, managing director at Peter J. Solomon Co. as quoted by the Wall Street Journal article cited above:

"The guy buying a [new] bond today is a guy buying a certain loss."

As mentioned above, this is primarily the result of the Fed's manipulation of interest rates. The FOMC's money printing bonanza has stripped the market of its ability to signal investors and this is truly something to be bemoaned. The idea of interest rates as "tools" of the Federal Reserve is a tragic mischaracterization, as explained elegantly by Sean Corrigan of Diapason Commodities:

"...the applicable rate of interest is not some abstract entity, utterly variable according to the whim of the banking system, but rather is one of the fundamental ratios prevailing in the vast, interconnected topology of exchange."

The subordination of key market figures to policy aims leads to perversities such as that which occurred in September when, in the wake of the inception of QE3, the spread between mortgage-backed securities and U.S. Treasury bonds collapsed to its lowest level on record leading me to remark at the time that

"...unless you believe that MBS have gone from being the scourge of the financial world in 2008 to just 25 or so basis points more risky than supposedly risk-free U.S. Treasury bonds in the space of four years, you can conclude that there is no longer any hope of reading anything into the signals the market sends."

Of course rates on Treasury bonds themselves are at historic lows; MBS just happen to be the flavor of the day and that is why the MBS spread tightened so dramatically in September, not because Treasury yields moved meaningfully higher. In fact, Treasury bonds yield so little that the dividend yield on the MSCI World Index is now greater than the yield on the 10-year Treasury bond:

Source: Citi, Datastream, MSCI

It isn't clear why more people aren't shouting from the rooftops that the sheep are being led to the proverbial slaughter. There simply is no worse time to be investing in investment grade or U.S. government debt and yet a record amount of cash continues to flood into these assets.

If you have recently gone long TLT, LQD, any comparable bond fund, or any securities which might partially constitute those vehicles, you are probably going to lose money either for yourself, or for your clients in the years to come. As the Wall Street Journal noted a few months back,

"Maybe the risk is down the road [but] sooner or later investors will face either a loss of money, or at best meager returns."

I would argue that for those with a bit of intestinal fortitude (otherwise known as 'patience'), placing wagers against Treasury bonds (NYSEARCA:TLT), investment grade corporate debt , and grossly expensive fixed income securities in general, is the closest thing to a sure-fire bet investors will ever come across.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.