Valuing Austrialian, Canadian, Euro, Japanese, US, and UK bonds

Tom Coyne publishes his estimates of which bond markets are overvalued and which are undervalued in the monthly Index Investor newsletter. Here's the section from the most recent letter.

Our government bond market valuation update is based on the same supply and demand methodology we use for our equity market valuation update.

In this case,

• the supply of future fixed income returns is equal to the current nominal yield on ten-year government bonds.
• the demand for future returns is equal to the current real bond yield plus the historical average inflation premium (the difference between nominal and real bond yields) between 1989 and 2003.

To estimate of the degree of over or undervaluation for a bond market, we use the rate of return supplied and the rate of return demanded to calculate the present values of a ten year zero coupon government bond, and then compare them. If the rate supplied is higher than the rate demanded, the market will appear to be undervalued. This information is contained in the following table:

	Current Real Rate	Average Inflation Premium (89-03)	Required Nominal Return	Nominal Return Supplied (10 year Govt)	Return Gap	Asset Class Over or (Under) Valuation, based on 10 year zero
Australia	2.63%	2.96%	5.59%	5.12%	-0.47%	4.54%
Canada	1.83%	2.40%	4.23%	3.80%	-0.43%	4.17%
Eurozone	1.27%	2.37%	3.64%	3.13%	-0.51%	5.05%
Japan	0.49%	0.77%	1.26%	1.18%	-0.08%	0.79%
United Kingdom	1.47%	3.17%	4.64%	4.17%	-0.47%	4.58%
United States	1.67%	2.93%	4.60%	3.98%	-0.62%	6.13%

It is important to note some important limitations of this analysis. First, it uses the current yield on real return government bonds. Over the past forty years or so, it has averaged around 3.00%. Were we to use this rate, bond markets would generally look even more overvalued.

Second, this analysis looks only at ten-year government bonds. The relative valuation of non-government bond markets is also affected by the extent to which their respective credit spreads (that is, the difference in yield between an investment grade or high yield corporate bond and a government bond of comparable maturity) are above or below their historical averages (with below average credit spreads indicating potential overvaluation). Today, in many markets credit spreads are at the low end of their historical ranges, which would make non-government bonds appear even more overvalued.

Third, if one were to assume a very different scenario, involving a prolonged recession, accompanied by deflation, then one could argue that government bond markets are actually undervalued.

Finally, for an investor contemplating the purchase of foreign bonds or equities, the expected future annual percentage change in the exchange rate is also important. Study after study has shown that there is no reliable way to forecast this. At best, you can make an estimate that is justified in theory, knowing that in practice it will not turn out to be accurate. That is what we have chosen to do here. Specifically, we have taken the difference between the yields on ten- year government bonds as our estimate of the likely future annual change in exchange rates between two regions. This information is summarized in the following table:

Annual Exchange Rate Changes Implied by Bond Market Yields

	To A$	To C$	To EU	To Yen	To GBP	To US$
From
A$	0.00%	-1.32%	-1.99%	-3.94%	-0.95%	-1.14%
C$	1.32%	0.00%	-0.67%	-2.62%	0.37%	0.18%
EU	1.99%	0.67%	0.00%	-1.95%	1.04%	0.85%
YEN	3.94%	2.62%	1.95%	0.00%	2.99%	2.80%
GBP	0.95%	-0.37%	-1.04%	-2.99%	0.00%	-0.19%
US$	1.14%	-0.18%	-0.85%	-2.80%	0.19%	0.00%