Stay out of this bond market madness
Posted on 10 October 2010 with 2 comments from readers
In an increasingly desperate search for yield on capital investors are now prepared to accept some absolutely ludicrous bond offers. They would be better off paying themselves a small ‘return’ and running down their capital as all history suggests that this will preserve more of their capital. Bonds have become very risky to the downside.
Last week Mexico sold $1 billion in 100-year bonds, and demand was 2.5 times the amount placed. As our friends at Agora Financial pointed out: ‘the yield, at 6.1 per cent, was even lower than Mexico paid for 30-year bonds six months ago’.
Demand for debt
Closer to home we could highlight the obvious appetite for Dubai Government debt in a $1.25 billion bond issue, less than a year after the Dubai debt crisis rocked the world. Why are investors keen to borrow from emerging markets at such low rates of return?
It is down to a frantic search for yield. But how safe are these investments? Dubai has the backing of Abu Dhabi, but Mexico? This country has a long history of default and devaluation, so what is the chance of 100 years of monetary stability? It is utter madness.
Bond holders are working on the ‘greater fool’ theory that they will be able to pass on this asset before it becomes toxic. The trouble with this argument is that the ‘greater fool’ turns out to be the original buyer who cannot pass the toxic parcel on before it explodes.
Financial commentators like Dr Marc Faber and Professor Niall Ferguson argue that the US bond market is close to a tipping point. That is when the bond market suddenly wakes up to the ultimate inability of the borrower to pay, usually when the cost of servicing this debt goes beyond a level consistent with repayment.
Bond market top
The sign that the bond market is reaching a top is the low yield itself. Bond prices are a function of their yield and will go down as yield rises. A falling bond market therefore brings much higher interest rates in its wake.
Equity and real estate markets are only held at present levels by low interest rates. Money printing or quantitative easing is seen as the answer to all prayers at the moment but actually it is the achilles heel of the whole system. For it is QE that will finally push the bond market over the edge and bring down the whole house of cards.
Money will then find its own level. Holding cash on account will be more attractive and precious metals will soar in value along with most commodities. And only when interest rates begin to come down again will equity and real estate prices start to recover from a very sharp sell off.
The idea that money can smoothly rotate from bonds to equities is the most dangerous illusion in financial markets today, and those accepting low yields on bond issues right now will lose their shirts. This is going to be about the destruction of capital not its rotation from one asset class to another.
2 Comments posted by readers:
Excellent advice here, Peter!
For those readers who may “still” be contemplating buying bonds of any type (and especially for those who are tempted to buy junk bonds ), stay away.
Stay far, far away.
P.S. The only “safe” bonds are the very short term (i.e. 90 day duration) government bonds, such as the US Treasury’s 90 day bills. You’ll earn practically no interest, but you’ll be able to sleep at nite.
P.S.S. for those who are still thinking about the allure of bonds, go back and read Peter’s commentary again! You’ll be glad you did!
“Behind that ability is a startling transformation in the country’s public-debt profile compared with the mid-1990s. In 1994, at the time of the so-called Tequila crisis, the country’s federal government external debt was equivalent to 16.5 per cent of gross domestic product. On Wednesday, it is 4.8 per cent of GDP, just less than 20 per cent of the total debt.”
From this FT article.
Ed Note: and in 20 years or 50 or 90 years?