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Don’t Yield to the Bond Bubble

4 minute read
Rana Foroohar

Remember the good old days–you know, before 2008? Spirits were high, politics was less fraught, and making money was easy. We all know how that ended. Today, investors wouldn’t dream of expecting double-digit returns; they just crave a safe haven–someplace to stow whatever assets and sanity they have left while they fret about the euro-zone crisis, the U.S. elections and fiscal cliff and a potential global double-dip recession.

Trouble is, the panicky flight to safety is creating a new kind of bubble, this time in the U.S. bond markets. The supply of safe assets, which historically meant AAA-rated government bonds, mortgage-backed securities and gold, has been declining precipitously over the past few years. Forget about Fannie and Freddie’s laughable mortgage bonds, gold is 14% off its peak and fading, and the downgrading of rich-country debt since 2007 has been even worse. Back then, 70% of it was top shelf–today, it’s about half that. In a world in which AA is the new AAA and even bank deposits aren’t considered completely safe (as MF Global reminded us), U.S. Treasuries are the last last resort; as investors have flooded into them, yields dropped to 220-year lows. The practical result is that if you own T-bills, you are basically paying the government for the privilege of babysitting your money while you go nowhere.

The cycle is likely to continue over the next few years as the Fed, spooked by the feeble economic numbers of the past few months, has extended its Operation Twist to hold interest rates (and thus bond yields) down longer term, to keep prodding borrowing and investment. And indeed, there’s a strong case to be made that all those with decent credit who can borrow–consumers, countries, companies and governments–should dive in, since rates won’t be this low again in our lifetimes. Frankly, you’d have to be daft not to find projects that would pay a 3% annual return in the next few years. Consider some of the big, broad investment stories of the moment, like the homegrown energy boom in the U.S. or the growth in emerging markets. (Sure, those markets are slowing, but they’ll still need a lot more electricity, steel and construction equipment over the next decade.)

And remember real estate? Ouch, you do. Sorry. But it’s looking to be a safer bet. The asset that caused our financial freak-out has, by many indicators, bottomed out. Building permits, the leading indicator of future construction, jumped nearly 8% in May; that sets the stage for some major construction this summer. “Interest rates are low, prices are low enough to encourage buying, and yet rents are rising–a kind of dividend which may well beat inflation,” notes Paul Ashworth, chief North American economist at Capital Economics. Bargain-basement condo in Florida, anyone?

But the most profound investment takeaway from the brewing bond bubble is that we should redefine what’s considered a safe asset. Last January, I wrote that stocks were becoming the new bonds, as the smart money dumped government debt and picked up not only corporate debt–which has outperformed global sovereign debt since 2008–but also blue-chip equities. It’s a trend that has only gained steam with the euro-zone crisis. As a recent Bank of America Merrill Lynch (BOAML) report noted, Portugal’s equity market is now the size of Whole Foods.

The logic isn’t hard to follow. After all, which would you rather own: exploding European bonds, T-bills that lag inflation or the stock of a global franchise firm (think Coke or Intel) that is flush with cash, building its brand in the world’s fastest-growing markets and paying out a safe, predictable, inflation-beating 3%-a-year dividend in the meantime? What’s more, there’s reason to think these stocks will rise–every new bull market in equities since the 1920s has coincided with an inflection point in bond yields. If it’s a good enough strategy for Warren Buffett, it’s good enough for me.

The final point to consider when investing in the age of anxiety: good financial management tops fancy financial engineering. Markets and companies that entered the postcrisis era with strong balance sheets have outperformed those that held more debt (often taken before rates were quite this low) by 51% since the start of 2009, according to a BOAML report. Not only are they well placed to grow by snapping up fire-sale assets, but they’ll also be in a much better position when the bond-and-interest-rate worm begins to turn and capital becomes a lot more expensive than it is now. With T-bill yields as low as they are, that day feels very far away. But wise investors should remember that every bubble–even a bond bubble–eventually bursts.

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