Weekend reading

Good reads from around the Web.

I first feared signs of a UK and US government bond bubble back in December 2008, writing:

With these crazy yields on government debt it’s getting too expensive to be a bear.

I believe the West can avoid deflation, and so I’m buying cheap equities, not expensive government debt.

At the time UK 10-year gilt yields had recently fallen below 3%, and short-term US treasury yields had briefly turned negative, which meant investors in them were effectively paying the government to hold their money.

I saw this pile into bonds as a sign of the extreme gloom and panic in the market, and worried that it would unwind with costly consequences. Equities looked much more attractive.

A good call? Not exactly.

As regularly readers will know, I have no problem admitting my own mistakes. But this was a case of half-right, but at least half wrong.

Equities have indeed done very well since December 2008. If you’d put your money into a UK FTSE 100 tracker and reinvested dividends at the time of my post, you’d now be more than 60% up.

I was right, too, that investors were clearly ultra-fearful (which was exactly why we had a great opportunity to profit from the stock market).

But there’s no denying I was wrong about those low bond yields being unsustainable. Money has kept piling into bonds of all shapes and durations for the past five years. The initial bond mania turned into a mass exodus from equities, driving yields ever lower.

As this graph from the Fixed Income Investor site shows, UK government bond yields approached 1.5% in late 2012.

What a downer….

It’s a small consolation that nobody reading this in the UK has never known such tiny long bond yields, and virtually nobody would have thought them even possible a decade ago.

Just another reminder of how hard it is to fathom the markets.

That was then, this is now

As we start 2013, there’s a lot of renewed chatter – and even fear – that this great bond bubble could finally be about to burst.

A sharp move up in yields last week in the wake of the US fiscal cliff resolution is being seen as a catalyst for this long-awaited unwinding.

There’s good reason to expect yields to rise, and hence bond prices fall. Ten-year gilt yields of less than 2 to 3% make little sense in an environment where inflation is running ahead of that. Unless we go into another big recession or even a depression – and hence see deflation – then sooner or later people will get fed up with the value of their bond holdings being eroded in real terms.

As a consequence, The New York Times is one of many outlets reporting that the bond craze could run its course this year:

“Mathematically, it’s next to impossible to get the kind of returns on bonds you’ve seen over the last few years,” said Kate Moore, the chief global equity strategist at Bank of America.

When the turn does ultimately come, it is likely to cause pain for at least some of the people who have been investing in bonds in recent years.

“You don’t want to be the last one out the door when the trends turn,” said Rebecca H. Patterson, the chief investment strategist at Bessemer Trust. “All good things come to an end and we want to make sure we’re in front of it.”

An article on a blog called Mutual Fund Observer puts these fears more colourfully:

We’ve been listening to REM’s It’s the End of the World (as we know it) and thinking about copyrighting some useful terms for the year ahead.

You know that Bondpocalypse and Bondmageddon are both getting programmed into the pundits’ vocabulary.

[We also suggest] Bondtastrophe and Bondaster.

It’s this kind of fear that has prompted Telegraph writer Ian Cowie to take what he says is the biggest bet of his life:

Contrary to the conventional wisdom that people should raise their exposure to supposedly low-risk bonds and reduce shareholdings as they get older, I did the opposite and sold all the bonds in my company pension to buy shares.

Now that’s an ultra-risky move, and not one that many advisers would recommend.

I don’t own any government bonds, but I’ve got 25-30 years ahead of me (touch wood!) before I’ll likely be required to live on my savings.

I could ride out another savage bear market. Could Mr Cowie?

How to deal with the bond bubble

That said, I do feel for you if you’re in your later years and you’re trying to decide what to do in the face of these extreme markets.

Anyone retiring since the mid-noughties has already had to decide whether to turn their pension pot into an incredibly low-yielding lifetime annuity.

Now the next round of retirees face the possibility of their retirement pots being cut down to size, if and when those low yields finally reverse.

However it’s important to remember a few things.

  • Firstly, most long-term pension savers would have already benefited from the rise in bond prices over the past few years. You can’t really enjoy the proceeds of a bubble and then cry foul when it bursts.
  • Secondly, even this kind of seemingly extreme bond bubble is not the same as an equity bubble. We have looked before on Monevator at the consequences of a crash (see the links below). While you wouldn’t exactly order one for yourself and a double helping for the lady, it’s very hard for a bond crash to be as catastrophic for an individual as an equity slump.
  • Finally, most Monevator readers probably only have 5-40% in government bonds. A 20% holding in bonds falling by a quarter is still a 15% holding in bonds – and it would very likely come with a stronger rise in your equity holdings. Meanwhile your bonds are protecting you from bigger downside risks, like a 60% fall in the stock market.

What am I doing? Right now I prefer cash to bonds when it comes to cushioning my portfolio. But deciding between them is not a risk you have to take.

Remember cash and bonds are not the same thing.

Perhaps the biggest risk of the bond bubble bursting is a disorderly market that sees institutions and others scrambling for the door at once. Given that Central Banks have been mighty buyers of bonds due to QE, any sudden unwinding could get very messy.

But you and I don’t have any good way of knowing how likely that is, or even what we should do about it.

Staying diversified, rebalancing as necessary, and not trying to be clever is likely to prove the best approach for most in the long-term.

More reading from Monevator on bonds and the potential burst:

Don’t panic, Mr Mainwaring!

From the blogs

Making good use of the things that we find…

Passive investing

Active investing

Other articles

Product of the week: The online lender Frodo is offering flexible short-term loans to those who’d otherwise use punitive bank overdrafts, says The Guardian. Remember that by far the best long-term solution is to restructure your finances so you never need to use debt.

Mainstream media money

Passive investing

  • Vanguard’s index changes prove no big deal – Index Universe
  • Another poor showing for active funds – Swedroe/CBS
  • No wonder ever more US investors are turning passive – WSJ

Active investing

  • Few new commodity ETFs in 2012. A contrarian signal? – Barrons

Other stuff worth reading

  • Only fools claim to know the future – FT
  • Inflation impossible to measure in a service economy – Slate
  • Let diversification do its job – New York Times
  • Women are better retirement planners – Wall Street Journal
  • How to think about risk in financial planning – Swedroe/CBS
  • HMRC publishes photos of top tax dodgers – Flickr and The Telegraph

Book of the week: Stock pickers might want to check out What’s Behind the Numbers?, a new book exposing the various ways in which companies try to fiddle their earnings. It comes highly commended by the excellent Clear Eyes Investing blog.

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