Bond Bubble: Color, Perspective, And Loss Projections

Includes: HYG, LQD, TLT
by: Colin Lokey

When asked last Friday if there was a bubble in the bond market, Bill Gross, founder and co-CIO of PIMCO and the man who is affectionately called the "Bond King," said the following:

"Well yes of course there is and it's been bubbled for several years and it is perhaps reaching its peak...yields are at zero and unless you're in Switzerland that represents a rates going lower."

The reference to Switzerland (circa the 1970s presumably) should actually be extended to include Sweden and more recently, Denmark.

In what Societe Generale (Soc Gen) recently called "The Scandinavian Experiment", the Swedish Riksbank forced its deposit rate to -.25% in 2009 in order to stimulate interbank lending and in July of 2012 the Danish central bank introduced a program which automatically rolls reserve balances in excess of a predetermined threshold (around 10 billion euros for the total Danish banking system) into the deposit facility where the rate is -.20%.

There are problems with this approach that suggest it will not be widely used as a tool in the fight against sluggish credit growth. As Soc Gen notes, the tendency for negative rates to reduce profitability at major financial institutions in conjunction with the fact that recent evidence suggests negative rates have little impact on banks' propensity to hoard cash (for instance, Danish banks' holdings of 7-day, negative rate, certificates actually rose in December), together mean that

"...overall, the benefits of pursuing negative interest rates would appear more obvious in countries targeting the exchange rate, rather than for the purpose of increasing lending."

So unless the dollar begins to rapidly appreciate in the midst of the single largest coordinated, government-sponsored effort to debase in history, negative rates seem unlikely here in the U.S.

Yields then, can't go lower and that means prices aren't going any higher. So a bet on a continued rally in Treasury bonds is a sucker's bet. What about corporates? Despite the fact that yields are historically low there as well, the spread between corporate yields and Treasury yields could theoretically compress further, meaning the rally in corporate bonds could still have some legs. Readers can judge for themselves how likely that is based on the following graph which shows just how far that spread has come in since blowing wider by some 600 basis points from 2008-2009:

Source: Gluskin Sheff

To be fair here, the spread is still above its pre-bubble, long-term average, but just by a shade. In fact, David Rosenberg thinks corporates represent an attractive opportunity in 2013 (the following quote is taken from a summary of Rosenberg's outlook presented on Zerohedge):

"$1.7 trillion in cash on U.S. corporate balance sheets [means that] even though yields have plunged in the past year, corporate bonds remain a solid investment given prospective low default risks, especially given still-wide spreads relative to the government sector."

While I do not pretend to be wiser than David Rosenberg, I nonetheless maintain that investors should weigh the risks before continuing to throw money at corporate bonds. By way of illustration and in order to put some numbers to my naysaying, consider the following excerpt from a recent research note from Fitch entitled "The Bond Bubble: Risks And Mitigants":

"If interest rates were to revert rapidly to early-2011 levels (a 200 bp rise), a typical investment grade U.S. corporate bond ('BBB'; 10-year maturity) could lose 15% of its market value, with a longer duration bond (30 years) suffering a 26% valuation loss in this scenario."

The following chart shows what the losses would be for different maturities under different scenarios in terms of the magnitude (in basis points) of a hypothetical rate increase:

Source: Fitch

The question then, is whether the potential to pick up a few percentage points worth of gains on a last gasp compression in the spread between corporates and Treasuries is reason enough to risk losses of between 5 and 25% of principal in the event rates should begin to rise sooner rather than later.

In my opinion, the potential reward does not justify the risk and as such, investors should be wary of corporate bond ETFs and be downright frightened of Treasury bond funds. The proactive approach is, as I have said before, to bet against corporate bonds (NYSEARCA:LQD) (NYSEARCA:HYG) and Treasury bonds (NYSEARCA:TLT). Just remember one thing before entering these trades: patience is a virtue.

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.