Demand for government bonds sparks bubble fear

For investors, bubbles are nothing new. In recent years alone we've had the dot.comcollapse, the CDO bubble that preceded the credit crunch and, of course, the over-heated domestic property market. But could we be on the brink of yet another?

Since the collapse of Lehman Brothers and the subsequent banking and sovereign debt crises, investors have fled to safety, seeking out safe havens such as gold and the government bonds of the stronger nations.

The demand for bonds has been most notable in the US, where, since 2008, investors have put $900 billion into bond funds, while withdrawing $410 billion from equities.

But it’s not just happening there. In the UK, bond funds were the best-selling retail funds from January to August of this year, according to the Investment Management Association (IMA), while in Ireland, investors are looking to German bunds to protect their capital.

This rush into bonds has seen prices soar and yields fall.

“In effect what’s happening at the moment in bond markets is that your core bond yields are yielding so little, that anything outside the core is in demand, even though there’s a risk attached. Bonds are hugely sought after,” says Ryan McGrath, bond dealer with Dublin broker Cantor Fitzgerald.

More stable

According to McGrath, the latest wave in bond price appreciation is driven from pronouncements at European summits over the summer, including ECB president Mario Draghi’s assertion that he would do “whatever it takes” to save the euro.

“Since then, the ECB is starting to win over investors [to the idea] that the risk to euro break-up has decreased quite significantly. While there are still outstanding risks, investment risks have decreased over the last few months,” he notes.

Prior to this summer, the re-allocation of capital from the periphery nations into the core countries as investors tried to preserve their capital drove up prices – and pushed down yields. Germany, for example, is issuing two-year bonds at 0 per cent.

With a more stable background, however, investors are now seeking out higher yield opportunities by investing in other regions – such as Ireland – which offer a better yield.

But such demand for bonds is leading some to suggest that they are now approaching bubble level. Global managers such as GMO have indicated that they are selling out of sovereign bonds while, last month, Allianz, Europe’s largest insurer, said low interest rates had caused a bubble in the government bond market.

Donal O’Mahony, global strategist with Davy Stockbrokers, concedes that bonds may be mis-priced.

Any time you see negative yields there could be a mis-pricing in that. But it’s a reflection of the euro system where capital has parked at the core,” he says. “Investors are parking their money in a negative yielding bond because the currency is perceived to be stronger.”

In any case, not everyone is bearish on bonds. Dan Fuss, vice-chairman and portfolio manager at the $182 billion Loomis Sayles fund, told Reuters recently that he is still upbeat.

“I wouldn’t call (this market) a bubble – I’d call it a very strong market,” he said, adding that it was hard for bonds to bubble, because they are fixed contracts.

McGrath agrees. “I would see the current trade, the search for yield trade, continuing in the first half of 2013,” he says. He believes that as issuers return to the market, prices may recede gradually.

“Limited supply is probably going to keep prices elevated; but as more supply and bonds come onto the market, we may see some price pressure easing,” he says.

Until recently, the major fear for bond investors was default, but for O’Mahony, 2013 is set to be a different year.

“Maybe the year is ending with considerably less concern about Greece. Now there is a begrudging acceptance that they might stay within the EU,” he says, and money is starting to “inch” back once more to the peripheral nations from the core countries. He points pointing to rising deposits in Ireland.

Against this improving economic backdrop, O’Mahony sees high peripheral yields as being “anachronistic”. But for now, the yield Ireland offers investors to hold its debt remains attractive. And there are plenty of investors making money on it.

Franklin Templeton’s Michael Hasentab reportedly has a 10 per cent stake in Irish government debt, and has done phenomenally well on this investment so far. But what if he were to sell out of it?

“It would be extremely difficult for him to start large scale selling of Ireland because he holds so much of it. It would be a risk if he decided to exit Ireland at the moment, but it would be very difficult for him to do that in a managed fashion,” McGrath notes.

If Ireland’s recovery continues, O’Mahony can see a rating upgrade on the horizon, which will “open up the gates to traditional investors into Irish government debt to re-engage”.

While Hasentab has indicated that he will hold his bonds to maturity, if traditional bond investors come back to Ireland, he could potentially sell his holdings into a rising market.

Peripheral crisis

But what of the traditional bond risks, such as rising interest rates?

When interest rates rise, the price of bonds fall, but this is really only a problem for investors who don’t intend to hold their bonds until maturity. In any case, McGrath doesn’t see such a risk in the short-term.

“Potentially, further down the line,” he says. “We don’t see interest rates as being an issue in the short to medium term because the economic background in Europe, as well as the peripheral crisis, should keep interest rates in check.”