Investors have no reason whatsoever to fear that the bond market is in a bubble, according to Thomas McMahon (pictured), fund analyst at FE Invest. 
McMahon believes that investors have been far too negative on the asset class over recent years and argues that they still provide important yield and diversification benefits.
The fixed income market has certainly been turbulent over the last year or so, with the unusually long market cycle causing yields to remain low and prices in the asset class to increase.
The performance of bonds and equities even converged during last year’s “Black Monday” – when a genuine bubble in the Chinese stock market did end up bursting – leading many investment professionals to warn against buying into traditionally ‘safe’ fixed income assets. As a result, a number of income-seeking investors opted to buy into dividend-paying mega-cap stalwart, or ‘bond proxies’, instead.
Fixed income has performed well year-to-date though, making strong returns in an otherwise choppy and sideways equity market.
Performance of sector vs benchmark in 2016
Source: FE Analytics
However, this doesn’t mean that there aren’t still fears about holding the asset class – in an article published yesterday, FE Alpha Manager David Coombs told FE Trustnet that he would now rather hold cash than bonds due to high levels of volatility in the fixed income market and because of Brexit fears.
“I do think your AA-and-above bonds will rally because the Bank of England will be forced to announce emergency cuts in interest rates [in the case of a Brexit] and may even announce further QE to flood the market with liquidity and that could mean yields fall a bit further over the first few days,” he said.
“The trouble is, that’s a big bet to make and I’m not willing to do it – the risk that we stay in and yields rise quite quickly is too great for me. I’d rather hold cash at this level, especially seeing as there is more volatility in the bond market at the moment than there is in the equity market.”
In a report released on Tuesday, CrossBorder Capital warned that a bond bubble is on the verge of bursting as a result of increasingly high prices in the asset class and the subsequent collapse in term premia (the level of compensation awarded to investors for holding higher-risk, longer duration bonds), the potential for a boost in inflation caused by a rise in oil prices and the fact that there is no longer capital flight from China, which supported fixed income assets last year.
“In 2007/08 world stock markets were pushed too close to the sun by the spiralling shadow banking markets. In 2011/12 gold and commodities, spurred by soaring central bank liquidity, followed. Now, driven by a scramble for ‘safe’ assets, it is the turn of government bond markets,” the report said.
“Ironically, their term premia have been driven to such low extremes they now look more like risk assets than ‘safe’ ones. In this topsy-turvy world, investors have been buying bonds for capital gain and equities for yield. Treasuries look vulnerable to both domestic inflation shocks and global capital flow shocks.”
McMahon, however, disagrees. While he says that term premia could justify a trade away from longer-dated debt over the short term, he argues that this does not mean investors should sell fixed income as a whole and remove their exposure to the asset class.
He also believes that most investors are still buying fixed income assets for their yield and diversification benefits rather than for capital gain.
“We do not think that there is a bond bubble, we don’t think it’s an appropriate use of words in this case,” he said.
“A bubble is when people are essentially speculating on an asset but are divorced from the fundamentals, so the asset is rising in price and people think there’s going to be a greater fool buying from them, they’re not really looking at the fundamentals of what they’re buying.”
“I absolutely don’t think that’s the case in bond markets at all. I think people are buying bonds on what they view as the fundamentals. Of course, that doesn’t mean they aren’t wrong about those fundamentals or that valuations aren’t high or that certain areas of the bond market aren’t overvalued, but that’s not the same as it being a bubble.”
The fund analyst says that many of the arguments regarding the bond bubble treat the asset class in the same way as equities, particularly regarding its supply and demand dynamics. However, he points out that bond investors are buying into the asset class for entirely different reasons and have different requirements from equity investors.
According to McMahon, the vast majority of the bond market is dominated by either insurers, large institutional investors that own pension funds or sovereign wealth fund managers. As such, he says that a mass exodus from the asset class is highly improbable.
“Particularly in the case of pension funds and insurers, they are very tightly restricted in terms of what they can invest in for regulatory reasons,” he explained.
“That’s important because you’re not going to a get a rush for the exit in bond markets, it’s not like an equity market.”
“Many of these pension funds and insurers are holding bonds to maturity and what they’re doing is matching the duration of their liabilities. If you’re running a pension fund with a liability with a 30-year time horizon, you need to find an asset that will match that 30-year liability and that will typically be a 30-year bond.”
According to data released from BlackRock, open-ended mutual funds account for less than 13 per cent of investors in US debt, which McMahon says is a small percentage of the market in terms of the investors who are potentially speculating on the price of the asset class and could therefore cause market movements.
In terms of the argument regarding the asset class’s low yields and that this could suggest a bubble, the fund analyst believes that this is also a misconception caused by an unusually high inflation spike during the oil price boom of the 1970s.
He points out that, if investors were to look at data during the 1950s and 1960s, they would find that yields remained between 2 and 3 per cent.
Because of current macroeconomic factors such as the aging population and the historically low oil price, he says that yields have simply returned to more normal levels.
“In the 1970s, the oil price increased, inflation got out of control and interest rates in the US were massively ramped up to bring down inflation rates,” he explained.
“This is the anomaly. If you were to look at real yields, you would have a much shallower course. What drives bond yields is growth and inflation expectations fundamentally, so the idea that yields should revert to 10 or 15 per cent is fanciful.”
“The only reason they would do that is if inflation and growth rises to similar levels and nobody that I’m aware of thinks that is a realistic possibility. That’s where a lot of the bond bubble argument comes from – investors looked at the figures post-1980 and they didn’t look at anything beforehand.”
Another point that McMahon says is important to consider is that a certain extent of the “fear mongering” regarding the bond market has come from quotations from the fund management industry, which has earned a significant amount of money through selling people more expensive absolute return funds as an alternative to bonds.
Not only does this mean that there are potentially motives for warning investors off of bonds, he adds that gilts have actually provided far better diversification benefits than many absolute return vehicles over the years.
Performance of sectors vs benchmark over 3yrs
Source: FE Analytics
“Investors shouldn’t be worried about a bubble at all. Different investors have their own concerns and this has led to a lot of talk regarding a bubble,” he continued.
“You also have to remember that some of the investors selling bonds are multi-asset managers – they have more of a trader’s perspective. They have a different mandate and if they think there’s relatively less value in fixed income, then they’ll hold less fixed income, but that’s an entirely different issue from whether there’s a bubble or not.”
“I think your average investor has been too worried about the bond market.”
