Burst of the bond bubble could leave the biggest mess of all

The two big investment bubbles that most people worry about are stock market and property bubbles. But there is one bubble that has been growing for years, and few people aside from investment specialists seem to worry about it at all.

It is known as the bond bubble, and if it bursts the fallout could make it the messiest bubble of all.

This moment could soon be upon us.

Tom Elliott, an international investment strategist at the Dubai-based financial advisers Devere Group, believes we are now in a bond bubble. “I would give a 40 per cent chance it bursts this year, 40 per cent next year and 20 per cent in 2017, as the US Fed raises interest rates and global monetary policy tightens,” he says.

The bond market has been enjoying a bull run for an incredible 35 years, something unimaginable for shares or property.

The market has swollen to a head-spinning US$76 trillion in that time, and any fallout could blow up other assets as well, with shares and property right in the firing line.

The longer the bull run in bonds continues, the more nervous investors have become.

Bill Gross, the most renowned bond manager of all, has been writing anxiously about “the sense of an ending” to the great bull run that began in 1981, predicting it will culminate in a time of “great unrest”. He adds ominously: “Like death, only the timing is in doubt”.

Other famous investors, including Warren Buffett, George Soros and Jeremy Grantham have also suggested that the bond super-cycle may be finally exhausted.

You may have seen newspaper headlines warning of a “global bond rout” that has wiped about $450 billion off bond values in recent weeks as investors panic that prices have risen too high.

Exactly how scared should you be?

Forget those offshore investment bonds that financial advisers are constantly pestering you to buy. Bonds are much bigger than that.

Governments around the world issue bonds to fund their spending commitments (and their debts), while businesses sell corporate bonds to raise the money they need to grow.

If you invest in bonds, you are effectively lending your money to the government or company.

In return, they pay a fixed rate of annual interest and return your cash when the bond matures after, say, five or 10 years.

The riskier the bond, the more interest the issuer has to pay to attract investors. So low-risk 10-year US Treasuries were yielding just 2.19 per cent on June 1, while shaky Greek 10-year debt yielded 11.46 per cent.

Yields on rock-solid 10-year German bunds recently hit a record low of 0.05 per cent, and were even expected to turn negative, which would mean that investors were paying the German government to hold their money. One day we may look back on that as the turning point. The moment when, after 35 years of falling yields and rising bond prices, the trend reversed. Yields on German bunds have since leapt almost twelvefold to 0.59 per cent, which admittedly does not sound much.

The problem is that when bond yields rise, bond prices fall, so somebody who bought at 0.05 per cent has already lost about 5 per cent of the capital they invested. And it could get worse.

One reason yields are rising is the growing market expectation that the US Federal Reserve will finally increase interest rates, possibly as early as September.

Christophe Donay, the head of asset allocation at Pictet Wealth Management, says economic growth in the major economies is set to improve.

“The US should bounce back from a weather-affected first quarter, the euro zone continues its slow recovery and leading indicators in many emerging markets are picking up.” Mr Donay expects inflation to rise after the oil price recovery, in which Brent Crude climbed 30 per cent since January to about $65 per barrel.

All this suggests that the days of near-zero interest rates may be coming to an end, and that is bad news for bonds.

Nobody wants to be stuck holding bonds offering near-zero yields when inflation and interest rates are rising, as the value of their income is falling in real terms.

Hence that $450bn sell-off as panicky investors dumped their holdings and fled for the exits.

Mr Elliott says that although few UAE expatriates own individual government or corporate bonds, most will still have wide exposure to the fortunes of the bond market.

“You are likely to hold them in mutual funds, either in pure bond funds or as part of a multi-asset funds that may, for instance, hold 60 per cent of the portfolio in equities and 40 per cent in bonds.”

He says bonds play an important part in a balanced investment portfolio because they are less volatile than equities. But with bond prices at a 30-year high, investors should be worried.

“Low bond yields make them vulnerable to inflation, because that would erode the value of your income in real terms. Even the fear of inflation is a risk,” Mr Elliott says.

Higher interest rates would reduce demand for bonds, as investors can secure a better return from cash deposits. “History shows that when large central banks, particularly the US Fed, embark on a course of higher interest rates, bond markets can shatter.”

The damage will not be restricted to the bond market. “Stock markets, property and other assets will also suffer,” he says.

The shock waves would quickly reach the UAE. “Since the UAE dirham is linked to the US dollar, higher US interest rates will mean higher local borrowing rates, which could hit the property market.”

In Dubai, apartment prices have already fallen 2 per cent in the first quarter of this year, according to the property consultancy CBRE. Transactions dropped to 7,311 in April, half the level than the same month last year, according to the Dubai Land Department.

Other factors may be driving down demand, such as the new caps on mortgage lending, but wider global fears have played their part says Mr Elliott.

David Norton, the head of investments for the wealth advisers AES International, says most expatriate portfolios will contain some corporate and government bonds, and investors should be very concerned.

“While bond price movements shouldn’t be as volatile as equity price movements, history tells us that we need to be wary when prices are at extremes.”

Chris Ferguson, the director of the Dubai-based wealth advisers Credence International, says these are dangerous times because we are living in an “experimental period of economic history”.

“We have never seen what happens if interest rates rise from all-time lows after huge amounts of QE. Nobody has a crystal ball to tell us what should happen next.”

The UAE economy is giving mixed messages right now. “Oil price weakness has affected the oil sector, but on the other hand Emirates Airline has just announced its second-highest profit ever.

“The UAE stock market has done very well this year so far with a return of more than 12 per cent since early January, yet property prices have dropped, perhaps due to oversupply. The global bond market isn’t necessarily to blame but obviously sentiment plays a part.”

Perhaps the main reason most ordinary investors have ignored the bond bubble is that the bond mechanisms of this vast, sprawling market are tricky to understand.

But if the Fed pushes to increase rates and bond prices continue to fall, you can expect to hear a lot more about the bond bubble.

Options for investors to escape volatility

Some bond funds still give you a degree of protection against bond market volatility. David Norton, the head of investments for the wealth adviser AES International, says: “Our preferred fund is the Nedgroup Income Multifund, which brings together a range of bond strategies, including short duration and high yield, in a well-diversified portfolio.”

Chris Ferguson, the director of the Dubai-based wealth adviser Credence International, names two bond funds that should escape the worst of the volatility. “Vanguard Total Bond Market Index Fund, a passive fund with low charges of just 0.20 per cent a year. I also like the Loomis Sayles Bond Fund, which has outperformed the Barclays aggregate bond index in eight out of 10 years,” he says, adding that UAE investors should consider taking professional advice to see whether their portfolio is exposed to any further bond market sell-off.

However, investors should ensure their portfolio has exposure to a spread of different assets, to spread risk.

“This should include high-quality defensive stocks, short-duration bonds and a mix of other asset classes such as property, commodities and a small amount of alternatives,” says Mr Norton, adding that it may also be worth investing in gold as well as a hedge against inflation and any fall in bond or stock markets.

Rising interest rates won’t be all bad news. Higher rates could benefit UAE expatriates who send money overseas because the value of their dollar-linked dirhams will rise relative to other currencies, Mr Norton adds.

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