by The Economist
Bond yields are very low, but Japan’s example shows they may stay low
IS THERE a bond bubble and is it going to burst soon? The Spectator, a British political weekly, ran a cover story citing the existence of a bubble back in September 2011. Yields are even lower now than they were then.
Calling the top of an asset bubble is extremely hard, as sceptics of the dotcom boom in the late 1990s will recall. History suggests that buying government bonds at yields of 2% or less is a losing proposition in real terms; those who bought American Treasury bonds on a yield of 2% in 1945, for example, did not see a gain in their purchasing power until 1989.
But there is one important exception to the rule. Japanese ten-year bond yields fell below 2% in 1998 and have stayed below that level almost ever since. Thanks to deflation, investors have still managed to earn positive real returns. Betting against the Japanese bond market has been a losing game.
In a sluggish economy, it is quite plausible that rates will stay low. Paul Krugman, an American economist, points out that bond yields are essentially a forecast of future short-term rates. Since a return of these rates to pre-crisis levels (4-5%) looks highly unlikely in the near future, there can hardly be a bond bubble.
Others see the recent rise in bond yields as a sign that the tide is turning, particularly in Japan. But as the chart shows, yields have only pushed up from remarkably low levels. In Germany and Japan yields are still lower than they were at the start of 2012. Abenomics, and the 2% inflation target, must have encouraged some Japanese investors to sell bonds and switch to equities (a sell-off on May 23rd came only after a long rally); foreigners may also be less keen to buy Japanese bonds while the yen is sliding. At any rate, the vast scale of the Bank of Japan’s quantitative-easing programme means that the authorities have plenty of firepower to drive yields back down again, if they feel these have risen too far.
The apocalyptic view of government-bond markets is that a combination of high fiscal deficits and central-bank money-printing will eventually cause a rapid rise in inflation. This may prove to be true in the long run, but there is little sign of it yet. Inflation rates are generally falling and the same is true for inflation expectations, as measured by the gap between the yields on conventional and inflation-linked bonds. In fact, Japan’s economic policy might act as a deflationary force in the rest of the world, since the lower yen will allow Japanese exporters to undercut their competitors. Albert Edwards, a strategist at Société Générale who has been pushing his “ice age” thesis of falling bond yields and lower equity valuations since the late 1990s, argues: “We are now only one short recession away from Japanese-style outright deflation.”
The big fall in government-bond yields has had a similar impact on corporate borrowing costs. The polite term for junk bonds, the riskiest part of the market, used to be “high-yield”, but that is now a misnomer. American firms without an investment-grade rating borrow at less than 5%—a record low. As Jeremy Stein of the Federal Reserve noted in February, speculative elements have returned to the markets, including “covenant-lite” loans and payment-in-kind debt (where interest is paid not as cash but as more debt). Bond issuance has boomed, with $1.2 trillion-worth of bonds sold in the first four months of the year, according to Standard & Poor’s, a ratings agency.
Still, a recent research paper by Moody’s, a rival to S&P, argues that all this is not necessarily evidence of a bubble. First, the spread, or excess interest rate, paid by companies compared with governments is not as low as it was in 2006-07, when most people think a credit bubble emerged. Second, companies have been issuing bonds as a way of refinancing previous debts, rather than gearing up their balance-sheets. Third, corporate default rates are low by historic standards and, particularly in America, profits are holding up well.
Nevertheless, corporate bonds are inherently more vulnerable than government debt. If the world does shiver in Mr Edwards’s ice age, government bonds will keep their appeal but defaults on corporate bonds will rise. And if the inflationary school is right, corporate bond yields will soar (and prices plummet) along with government bonds.
So bond investors might face apocalypse, but predicting timing is tricky. A surge in inflation, a sudden change in central-bank policy and (for corporate debt) a relapse into deep recession could prove ruinous. But probably not this year.
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