Why bonds should carry a wealth warning

The UAE said yesterday that it is the latest country to be planning to issue bonds. This is more interesting in the emirates as it has not been done before. But governments around the world are rushing to issue bonds and investors would be wise to be weary of these offerings.

Bond investors are at risk from two directions: interest rates may rise depressing the capital value of a fixed-interest instrument like a bond; and the currency in which the bond is issued may fall in value.

Yields rising

Over the past week the holders of US 10-year treasuries have seen the value of their bonds fall with yields rising to almost four per cent, double the rate just a few months ago. At the same time the dollar has come under pressure yet again.

Bonds look like a safe, long-term investment, particularly with sovereign backing. It is true that they will always have a residual value unlike companies which can go bankrupt. But bonds can be devalued very quickly by inflation that pushes up interest rates and devalues a currency.

Even the most optimistic analyst of the global economy must acknowledge the very real dangers of inflation and devaluation today.

The doubling of the oil price in the past six months is inflation. We do not need to debate if or how it might happen. It has happened, and other commodities are also up across the board.

Dollar risk

Then there is the dollar which few believe can sustain its present value in global currency exchanges as the money supply is being hugely expanded to cope with bank bailouts and stimulus packages. More dollars mean dollars are worth less.

So why would anybody invest in bonds, even those denominated in dirhams which are only a proxy for the dollar given the fixed peg? It is not immediately obvious.

For governments a chance to raise debt and then watch it inflate away is clearly attractive. But for investors fixed rate bonds just have to be one of the worst investment options on the table, and perhaps that explains why equities are currently back in fashion, although all the smart money is in commodities.

This is looking at longer term bond investments, of course. In the shorter term traders see an opportunity to profit from a stock market correction by buying bonds now at cheaper levels and then to see them rise against falling equities.