Defining The Bond Bubble

by: JJ Butler

Financial bubbles are extended periods of extreme overvaluation. Overvaluation is a price substantially higher than intrinsic value. Often bubbles have positive feedback loops, distort the market pricing mechanism and end in implosion.

Bonds are fixed income securities with duration of 10 or more years. Bonds are the simplest of securities to value. At the time of purchase, the yield the investor can expect to earn is clearly stated. Bonds with a higher risk are priced at lower prices with a higher yield.

The risk of default is the credit risk. Credit is always higher on the capital structure than equity, thus credit is generally safer than equity. Credit risk can be mitigated by owning bonds of sovereign issuers who have a printing press, which creates the debasement risk inherent in bonds.

Evaluating the valuation of bonds is a matter of looking at the yield. Ten-year U.S. treasuries yield 1.79% and 30-year U.S. treasuries yield 2.95%. Conforming 30-year mortgage rates are currently 3.87%. Investment grade corporates are at 3.75% (5.49 year average duration) and high yield ('junk' bonds) are 7.11% (3.98 year average duration). With central banks targeting even small amounts of inflation, coupled with taxes, bonds are certain to provide negative inflation adjusted returns when held to maturity.

Credit as a percent of GDP has ballooned to levels dwarfing even the bubble of 1929. The U.S. Great Depression until 1933 was the defaulting of the debt. Left to itself, the credit crisis of 2008 would have deflated through default as well. Government intervention, however, staved off default by transfering debt and debt accumulation to the U.S. federal government. Thus 10% government deficits.

The great irony is the record federal deficits and debts and record-low yields. High bond prices, having experienced a historic 30-year bull market, have tremendous amounts of issuance and are the bubble. The long duration credit outstanding will not be paid back in kind.

Suppose the U.S. government implemented austerity and balanced its books. Because of the 10% deficit, GDP would immediately collapse 10% with further contraction because of the negative feedback loop. Default in the private and public sector would rule the day. Austerity has no friends in the political arena.

The other option, of course, is debasement. Zero interest policy, government backstops, operation twist, and especially quantitative easing are the new normal. Just as the credit bubble required an ever increasing size to stave off the painful restructuring of austerity, so shall money printing be required in ever increasing size. Bond investors can expect to be re-paid, and they can expect to be re-paid with a currency in vastly greater supply.

Continual European financial fears are a function of the credit bubble. Central banks are trapped by low interest rates, for if short-term interest rates are raised government interest expense will bust already bloated budgets. Witness 10-year Greece government securities commanding 27% interest rates; bond prices imploded over default expectations. Bond prices also collapse when the realization occurs the currency will be debased.

Huge distortions exist because of the credit bubble. The housing bubble is only one example. With the price of credit suppressed by central banks, business and governments have made tremendous ma-linvestments. The economy being distorted only adds to the difficulty of resolving the credit bubble.

For the investor, irrational exuberance has led many to decry an alternative investment strategy of barbell strategy. Investors can expect tremendous volatility in bonds prices prior to maturity. In short, sell bonds. Gold represented by the SPDR Gold Shares (NYSEARCA:GLD) is one alternative. Additionally, the equity of well capitalized and diversified companies producing real goods may be judged as safer than the credit obligations of the same business.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.