Bubble, toil and trouble as investors pour into bonds

WITH government bond yields dropping through the floor, analysts fear that over-egged double dip fears have inflated a bond bubble. A quarter of year-to-date inflows into exchange-traded funds (ETF) have gone into bond funds, so ETF investors should keep a sharp eye on the debate.

alarmists highlight the pace with which investment has rushed into advanced economy treasuries. Research by iShares shows that money is flowing into European bond ETFs at a growing pace, with 35 per cent of the last month’s new net assets going towards fixed income.

Beyond that, investors should consider the historically low level of treasury yields here and in the US. One-to-three-year note yields in the States are now well under 1 per cent and in just the past month, yields on 30-year US treasuries shrunk from 4 per cent to 3.72 per cent and 10-year note yields declined from 3 per cent to 2.65 per cent. “The bond market tends to be quite glacial, so these are pretty big moves,” says Charles Schwab’s Kully Samra.

Technical analysts are therefore convinced that something will have to force yields upwards before too long. The most likely candidate, according to RBS, is a reduction in fears of another global downturn and deflation. If this occurs, the likelihood of rate rise soon will also increase, which would severely damage bond values and burst the bubble. Interest rate rises erode the value of existing bonds because they make it more profitable to buy new bonds (which have a higher yield) than to buy existing, low-yielding bonds.

But bond-enthusiasts insist that the current economic uncertainty justifies buying treasuries. Evolution Securities’ Gary Jenkins says: “At the moment, people would rather sleep well at night than take on too much risk.” Moreover, bond investors only lose money due to a rate rise if they intend to sell before maturation. If not, the worst scenario will simply be to forego a potentially higher return, which, for pessimists on economic growth, is a chance worth taking.

Even so, any investor in need of a decent return over the next decade should ditch her bonds before next year’s likely rate increase. When rates do change, they could jump up quickly.