Why bonds suddenly look such a bad risk

Posted on 16 February 2010 with no comments from readers

The $300 billion Greek debt crisis has thrown the spotlight on government debt as an investment class. Greece cheated Brussels into thinking its debt was lower than now proves to be the case, hence the nasty surprise.

But actually a huge question mark hangs over the viability of long-term investment in almost any government bond at the moment. Put simply it is a matter of pricing: are bonds priced too low for the inflation outlook?

Inflation coming

Inflation as we normally understand it means upward price revisions for goods and services. But inflation is always a matter of the money supply. Too much money chasing too few goods equals inflation.

And where does the money supply come from? Well, actually the bond markets that allow commercial banks to create credit.

And what do we know that governments all over the world have been doing to counter the global financial crisis? They have been issuing more and more bonds, and even buying their own debt in a bizarre process called quantitative easing. So the money supply is rising, even if commercial credit is still actually shrinking.

Eventually that new money will find its way into global financial markets and cause inflation. How long will that take?

There is presently no immediate fear. Indeed, the most immediate prospect is a downturn in global equity markets that will rally the dollar and boost bond purchases, at least for a short time. Some think central banks are about to cause a stock market crash for that very reason.

But look at a 10-year British Gilt paying four per cent interest, or for that matter Greek bonds paying not much more. You have to be a bit of a loony to think that will represent a good buy over a decade.

In the 1970s bonds were dubbed ‘certificates of confiscation’ because inflation eroded their real value and gave them a negative yield after inflation. This time will not be different.

Bond yields are presently very low and bond prices therefore exceptionally high. What has gone up in price will go back down, not up further, or not for very long.

Deflation versus inflation

The confusing mixture is first deflation as house prices and equities fall, then inflation as governments overdo their rescues and finally something bordering on hyperinflation to eliminate debts. Timing this is very difficult.

If you are a bond holder then you hold debt, and that is not a position you want to have when inflation really roars and destroys debt.

In previous major financial crises this has always been the penultimate phase, and when the bond market implodes then comes the final, or ‘ultimate’ bubble as George Soros calls it, in gold and silver.

Thus while owning short-term bonds and cash makes sense in a stock market crash, a swift move into precious metals thereafter should be contemplated.

You do not have to go back far in history to find government bond defaults. Think Russia 1998, Argentina 2001. The wonder is surely that investors continue to believe governments have some kind of magic as creditors.