Has the Bond Bubble Sprung a Leak?

The fiscal cliff deal has made bonds look even more toxic...

IT WAS SHAPING up to be another be another strong year for US Treasury Bonds right up until the moment it looked like a fiscal cliff deal would be reached, writes Martin Hutchinson for Money Morning.

Since then, 10-year notes yields have been on the rise jumping by as much as 23 basis points since New Year's Eve.  Now you have to wonder whether or not the bond bubble has suddenly sprung a leak.

The problem is that had we gone over the "fiscal cliff", long-term US Treasury bonds would have remained a strong buy since the Federal deficit would have been cut by 77%. However that didn't happen.  Instead we got a deal with modest tax increases, tiny spending cuts and $64 billion of tax-exemption pork.

In those circumstances, long-dated Treasuries suddenly became a bad buy. In fact, in the wake of the deal I would argue they have now become practically toxic. But there is quite a bit more to this story than just Treasuries.

What's less obvious is that this toxicity now extends throughout the bond universe, to prime corporates, mortgage bonds, junk bonds and emerging market bonds. Here's the thing: In today's market, each of these categories has a different form of toxicity.   

Let me explain, starting with US Treasuries...

At the moment, long-term Treasury bonds are currently being supported by $45 billion per month of purchases by Ben Bernanke's Fed. In theory, that ought to prop up the price.

However, in practice, since the "fiscal cliff" deal has removed less than $100 billion per year of the $1 trillion deficit (we'll see an updated calculation when the 2014 Budget appears next month) there's still potentially more supply than demand.

What's more, it is very clear from the last Fed meeting that the Fed is closer to withdrawing some of that "stimulus" than it is to supplying even more.  

So the risk for long-term Treasuries is substantial. It could be triggered by either of two events: a market panic about the sustainability in US budget deficits or a surge in inflation. One or other is more or less certain within the next couple of years and very possible in 2013.  As I discussed earlier, I think inflation is could very well be the economy's hidden iceberg in 2013.

And make no mistake about it, if interest rates rise, the capital loss on your Treasury bonds will overwhelm the current pathetic interest they return of 2% or so. When it comes to prime corporate bonds, the risk is now two-fold with a combination of rising interest rates and credit downgrades. Here's why...

Corporate profits are currently at record levels in terms of GDP, much higher than they were in 1929, while interest rates are at record lows. That has encouraged corporations to overextend themselves. In fact, yield spreads over Treasuries have become so compressed that 10-year A-rated bonds are yielding less than 1% above Treasury bonds. When these yields begin to rise, credit quality will decline, so corporate bonds have two risks to their current price, not just one.

High yield "Junk" bonds have the same risk as prime corporate bonds, only more so.

Fed policies have driven investors towards more risky assets, benefiting high-yield bonds, which saw a record $300 billion of issuance in 2012.  Including capital appreciation, these high yield investments have returned over 15% on average to investors.

In this case, a rise in interest rates would not only affect the secondary bond market, it would also see a rise in defaults as happened in past credit crises, leading to losses of 25-30% or more for investors.

Mortgage bonds won't fare so well either. Mortgage bonds had benefited from a decline in interest rates, from a revival in the housing market, better underwriting and from $40 billion per month in Fed purchases.

As a result, mortgage bond yields of 2.34% only reflect a 0.4% premium over 10-year Treasuries. That's nowhere near enough to pay for their greater risk, which doesn't come from mortgage defaults but from duration uncertainty – mortgage re-financings fall when interest rates rise, so a mortgage bonds' effective maturity lengthens.

The Fed may also pull out of the market in 2013, giving mortgage bonds further uncertainty. However, when comparisons are to be made I'd rather be in mortgage bonds than corporates currently, let alone junk bonds.

Emerging market bonds sound like a good deal.  After all, emerging market economies continue to grow more rapidly than developed markets and many emerging markets have avoided the foolishness of  Bernankeism and fiscal "stimulus" deficits.

The problem is that the good emerging markets tend to have few bonds outstanding, so you are restricted mostly to buying the debt of the bad actors.

 In the JPMorgan Emerging Market Bond Index (the main global index) the seven most important countries are Brazil (badly run and Socialist), Russia (need I say more), Turkey, (very over-borrowed, flirts with bankruptcy frequently), Mexico (decent if unexciting credit), Philippines, Indonesia (neither terrible investments, but not the Asian investments you'd want) and Venezuela (run by a Marxist nut-job.)

Meanwhile, the countries you might want to invest in, South Korea, Taiwan, Malaysia, Singapore and Chile, have little or no foreign debt and so you'll have trouble buying their bonds.   

Get the safest gold at the lowest price by using BullionVault...