Has the collapse of the benchmark bond, the 10-year US treasury issue, marked a buying climax and the end of a bull run for government bonds?
Is this the top of the bull market for government bonds? Does a bear market lie ahead? Do investors stand to lose money on the safest securities in the market? I think so.
Bond market commentators are suddenly worried about volatility. The world's benchmark bond, the current 10-year US Treasury issue, suddenly rose 8.4% in October and collapsed 10.1% in November. That looks suspiciously like a buying climax.
Over the past 15 years there has traditionally been 40% correlation between the performance of gilts and US Treasury bonds, so UK investors ignore the US at their peril.
The last time market commentators seemed so concerned about volatility was just after the millennium and the concern was Nasdaq. Volatility was code for price declines and few seemed concerned while prices were going up. Now the situation is similar.
The case for a bear market in government bonds, and the fixed interest funds that invest in them, consists of seven parts.
• Price movements are most extreme at the long end, where the damping effect of a guaranteed redemption value is least pronounced.
• As interest coupons are fixed, prices must move to adjust yields for changing investor expectations.
• The required yield should match expectations for inflation and generate a small surplus to provide a real yield
• Currently, the real yield of 3% is close to the bottom of its trading range of 2% to 8% since the great bull market began in 1980
• The Bank of England's target inflation range is as close to zero as is practical, given the downward inflexibility of wages and the need for changes in relative wages.
• Inflation at 1.6% is even below the target range and indeed at the lowest level in quarter of a century (see red series on chart)
• Countries with negative inflation are mired in years of recession, for example, Japan or Argentina. That is unacceptable to a government seeking re-election.
While such arguments have been appropriate for some time, the sudden upsurge in volatility suggests that a change in direction may be upon us.
A couple of statistics indicate that the latest performance may be highly significant.
• The last month in which a comparable decline occurred was February 1999. There had been a rush to safe havens after the Long-Term Capital Management crisis, which was similar to the 'War on Terror' this autumn. In the year following that one bad month, the benchmark long bond fell a further 20% in value.
• November was the very worst month for US bonds in nearly two decades. That is as long as the great bull market in bonds has been running.
While technical factors have played an important part in the final upsurge of gilt prices, these now seem to be reversing.
For a time the UK government was running such a surplus that it was reducing its outstanding debts, thanks to buoyant tax revenues and low unemployment payments in the strong economic environment that existed until this year. As the economy weakens, the reduced supply of gilts has now been reversed.
In the UK, since the Maxwell crisis, pension funds have been obliged to match assets and liabilities more closely. This gave more mature funds an incentive to change their asset allocation in favour of long-term bonds, irrespective of market conditions. However, changes following the Myners Report have eliminated this artificial squeeze.
In addition to the cyclical stabilisers that are now worsening the government's cash flow, the chancellor is also hinting at a rise in taxation to pay for discretionary increases in social services, as a result of re-ordered political priorities.
It takes no sophisticated mathematics to calculate the downside potential. Taking market conditions since 1993 when UK inflation first fell below 2%, inflation has averaged 2.6%, the real yield has averaged 4.0% and the nominal yield has averaged 6.6% (see chart).
Thus, a return to average conditions would lead to an increase in long-term gilt yields from 4.7% to 6.6%, which equates to price declines of approximately 30%.
Worse, a return to the other extreme of the trading range would lead to an increase in gilt yields from 4.7% to 8.8%, which represents nearly halving of prices.
Fortunately, that overstates the bearish case for a typical UK fixed interest fund, for several reasons.
• Funds will generally contain bonds of various maturities so the overall negative pricing effect will be reduced.
• Furthermore, in as far as any decline may take a year or two to happen, accumulated income will partially offset the reduction in prices.
• In addition, the greater the proportion of lower quality corporate bonds, the more the fund will benefit from a reduction in spreads as the economy recovers
However, annuity conversion funds are fully exposed to the risks as these typically concentrate in precisely those bonds most at risk ' long-term British government securities.
For investors who look on bond funds as an alternative to equity funds, the choice is easy. On the one hand, this may be the top of a bull market in bonds, but on the other hand it is still close to the bottom of a bear market in equities.
Nick Dewhirst is chief executive of InvestorsRouteMap.COM
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