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Will the bond bubble burst?

Julian Hofmann explains why the bond bubble is unlikely to burst in 2013
December 21, 2012

It is probably true to say that Wall Street would have been a far less compelling film if its protagonists, instead of working in glitzy tower blocks on Manhattan, were in fact based at the UK government's debt management office in Philpot Lane. But, as the memory of Gordon Gekko's generation, and the fabulous returns from equities, fades into nostalgia, the hard reality is that for the past 20 years, lending to the UK, or the Germans or the US, has proved to be the single most profitable trading activity for investors, with inflation-adjusted returns of more than 40 per cent.

That inevitably leads on to the debate over whether the bubble in government debt, supported by loose monetary policy, low growth and an ageing population, will burst, taking other types of bonds with it. The short answer to that is that unless the fundamentals change radically, 2013 is not the year for the great bond bust - and here's why.

Interest rates can't go up until households have got debt under control

The freedom of having our own currency to debase means the new man at the bank of England, Mark Carney, has slightly more options than his counterparts in Europe. However, while there is broad agreement that interest rates will need to rise, this is not going to happen next year. To begin with, the deleveraging of household debt has still some distance to run.

Household debt in the UK has been flatlining since 2007, with the total household debt falling below £1.4 trillion. Certainly, the 9.3 per cent a year increase between 1993 and 2006 is but a distant memory. That hides the fact that we have started to repay both mortgage debt and credit cards at a faster rate than new loans are being taken out. Ultimately, until household debt is back to the historical average, interest rates will stay low.

 

 

Investors need income

Another reason why corporate bonds will continue to fly off the shelves is that investors have few other ways of generating a decent income. Conventional cash accounts barely cover inflation and the spate of missed earnings targets seen in the third quarter from companies is a warning about the security of dividends. Bond yields have also been under pressure, but at least investors can still find ways of earning a living after inflation through corporate debt markets.

Companies need the cash

Fundamentally, banks are not lending to businesses on reasonable terms and, with a new regime of regulation coming into force overseen by the Bank of England, yet more capital might be needed to staunch losses from delinquent loans. The only way for banks to bolster capital reserves without issuing more dilutive equity will be to clamp down on lending to companies.

A side effect of this will be that company treasurers will look more seriously at the bond market as a source of funding diversification, giving investors a new-found power of choice. Already we have some issues rejected as being ungenerous or too risky; or both in the case of haulage company Stobart's aborted bond. If more companies issue bonds next year then investors will have a considerable amount of choice and pricing power. But that means coupons will shrink.

 

 

The Germans will keep paying

The recent ratification by the Bundestag of yet another bailout for the Greeks is another plank under the government bond market. Ultimately, Germany cannot afford to lose the discount the euro gives its export-orientated industries, which combined with some tough and timely welfare reforms in the early 2000s, has cut labour and manufacturing costs by up to 10 per cent. Frankly, with all those BMWs, machine tools and high-grade electronics flowing in greater numbers to emerging markets, the country can afford to bail out its nearest neighbours, and while that remains the case, the looser money policy that underpins government debt will continue.

The number of assets has fallen

What has happened over the past year is that investable bond assets have shrunk in size. Italian bonds were always a source of ready cash, but euro investors have shied away from these recently as Italy undergoes a renewed period of political turmoil. That has made investors buy up a diminishing pool of gilts, bunds and Treasuries and kept prices high. It doesn't help that the programme of quantitative easing (QE) effectively pits bond buyers against the central banks in the competition for safe assets. Banks and pension funds are also under pressure to increase the amount of capital they hold as protection against losses on their loan books. Given that these must be liquid and easily traded, the only real option is to hold a spread of gilts permanently on the books, further reducing the available supply.

 

 

What could happen to gilts?

The eurozone crisis is the single biggest factor in propping up the gilt market. If the countries that make up the euro can agree on a programme of economic integration that resolves the structural tensions within the single currency, then the money that has flooded into gilts from foreign investors could very easily exit, and quickly. The European Union has made some progress with a banking union agreement and the appointment of a banks supervisor for the entire zone (excluding the UK and Denmark). That should give the currency some stability by underpinning the health of its financial institutions. Further moves towards integration are stalled and it probably won't be until the new round of summits in the spring before any further agreements are made.

 

 

The Fed is still buying

The Federal Reserve recently surprised with its views on how success in its programme of bond buying will be measured. The bank has set itself the target of bringing down US unemployment to 5.5 per cent as the trigger point at which to end the QE programme, currently costing the Reserve $85bn (£60bn) a month. The risk to this is that asset prices, particularly in the now-recovering housing market, start to rise at a rate that threatens inflation getting out of control. It is hard to predict whether either a fall in unemployment, or a rise in inflation, will happen quickly enough next year for the Fed to reverse its policy completely – it has done this before, notably in 1980 and 1994 - but with a looming fiscal cliff and confidence low, the balance of probability is that the bank will continue to buy Treasuries and keep a floor under the price.