Bonds - The Next Bubble?

By Noel O'Halloran, Thursday, 22nd March 2012 | 0 comments
ohallorannMany investors believe, or are being told, that they can “de-risk” their investments by shifting assets out of equities and into core European government bonds. However, it is my view that government bonds will in fact be the weakest asset class over the next decade so there is a real danger that investors are switching into an asset which is seriously overvalued. Government bonds, even German government bonds, are NOT risk free!

Bonds have, it is true, outperformed equities over the last decade. But such outperformance is extremely rare. A decade ago, the strong performance of equity markets over the previous decade gave strong but mistaken comfort to those holding high levels of equities. There is a real risk today that the same mistake could happen again, this time as investors move heavily into very low yielding government bonds (German government bonds yield only about 2%).

The past decade as we know has been tumultuous and history will tell the large number of “unexpected tail-risk events” that happened during a ten year period. For investment markets this meant a decade of extreme asset movements, extreme volatility, and a couple of plunges into the abyss – and back. This has resulted in many aspects of conventional investment beliefs rightly being challenged. But there is now a risk that investors may treat the last decade as normal rather than abnormal, and plan accordingly.

Our macro outlook remains that the decade ahead will be one of slower but positive growth as we work through the headwinds from the amassed debts of the past decade. We know that over the last couple of years the world’s central bankers have taken unprecedented actions to stem the evolving debt crisis. They no doubt took their cue from the period of the Great Depression of the 1930s which demonstrated the lesson that monetary reflation is perhaps the only way to solve a massive debt crisis. As asset managers, a combination of a positive macro outlook and extreme asset class relative valuations gives us strong reason to believe that risk assets will be the strong winners over the next decade and that government bonds will be the weakest asset class.

Globally, investors have poured funds into government bond yields, and yields have fallen to extremely low levels (typically around 2%) in Germany, the UK, the US, and Japan. True, this was partly because of fears of prolonged global recession/depression. But those fears have very definitely receded at this stage, yet bond yields remain very low – for now.

The chart below shows the German ten-year bond yield versus the dividend yield on the European equity market. 

 Valuations and PEs   Bond Yld vs Eq Div Yld 

I look at this chart and see a very strong message: the relative valuation between equities and government bonds has become extreme. The “noughties” were clearly a lost decade for equities and especially relative to government bond returns. In 2000, the yield on German 10yr government bonds was almost three times that of European equities. Today, it is close to the opposite, with German 10 year bond yields at 1.9% and  European equities giving a dividend yield of about 4%. This is an extreme of valuation such as I have rarely seen over the last 25 years.

And remember this is in an environment where global central banks are attempting the greatest reflation exercise in 80 years. One thing is for sure – if they succeed, holders of 10-year bonds at a yield of 2% will see heavy losses!

As an exercise, suppose for a moment that over the next decade inflation in core Europe (Germany) averages around 2%, and that GDP growth is about 2%, both of which seem quite reasonable assumptions. If so, then theory tells us that fair value for German bond yields should be 4-5%. That would imply losses of more than 20% for investors buying them today. Risk free? Hardly!


We challenge the view that German and other core eurozone government bonds are “risk free”, and should comprise a much larger share of investment assets over the next decade. Such bonds may still be free of default risk, but not price risk, and investors run the risk of buying into assets which I believe are already in bubble territory.


Noel O'Halloran
Chief Investment Officer



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