Sovereign bond bull market bypasses investors             beats gold   

 

By Neil Behrmann

 

December 2008:- A major bull market has bypassed the press and a vast number of investors.


Mesmerised by sliding residential and commercial property values, equities, corporate bonds, hedge fund investments and commodities, the sovereign bond bull market has virtually been ignored. In the past few months sovereign bond prices of developed nations have taken off partly because they are a safe haven, but more importantly, they have locked in reasonable income.

The bond bull market started in mid 2007 when the collapse of two Bear Stearns hedge funds precipitated the global credit crunch. Even then, when amber lights were flashing, investors remained deluded as the real estate and equity boom continued. As can be seen from the table, investors who became fearful of the irrational optimism, have made extensive gains in government bonds while others have lost capital. Including income and capital gains, investors in ten year US treasury bonds have seen their income appreciate by almost 30 percent, while holders of other major sovereign bonds have also done well.

Sovereign bond risks


Holders of government bonds are subject to interest rate risk. If interest rates decline, the capital value of the bonds rise, but if they increase, the value of the bonds fall. The longer the redemption period, i.e. life of the bond, the wider the price fluctuation. Corporate bonds also fluctuate in line with the general trend of interest rates, but they are also vulnerable to credit risk. If the market perceives that a corporation is heading for financial problems, its credit rating is downgraded and its bond price declines. This usually happens in economic downturns and recessions such as now.  The “spread” i.e. the difference between the corporate bond yield and government bond yield widens. Since June last year, corporate bond yields have thus surged and the capital value of the bonds have tumbled.


In contrast, the flight to safety. central bank and market view that inflation could turn into deflation and consequent decline in interest rates, have caused a trickle of funds into government bonds to become a flood in recent months. Investors are panicking because short term money market rates, depending on the currency, have slumped to between 1 to 3 percent, an uneconomical rate for investors.

                 GOVERNMENT BOND YIELDS (%) DECLINE

                                                       

 

Jun

07

Dec

07

April 08   

Dec 08

Capital Gains Since June 07

Capital gains + income

US

5.20

4.17

3.75

2.66

22.3%

27.5%

Germany

4.70

4.30

4.13

3.04

15.0%

22.7%

UK

5.50

4.67

4.73

3.43

18.0%

23.5%

Japan

1.88

1.56

1.39

1.36

15.0%

16.9%

Australia

6.45

6.25

6.19

4.28

18.7%

23.9%

Gold $ per ounce

650

800

850

800

23.0%

23.0%

Source:- Marketpredict.com

Long term government bond yields are no longer a bargain, but the search for safety and better yields are still attracting investment flows. The test will be next year when a huge US Treasury issuance may overwhelm global demand, now that the dollar is more expensive. Similarly massive issues of European government bonds may also force yields up and prices down. On the other hand studies of the Bank of England have shown that the issues are small in relation to the global stock of bonds and in the past the extra supplies in disinflationary times have had limited impact on yields.


If the market perceives that interest rates will decline further or remain low in a recession and deflationary economic environment, government bond prices will not tumble and may even rise further. But if the economies revive and inflation rears its head again, bond prices will tumble.

Gold against sovereign bonds


Gold denominated in dollars has generally underperformed sovereign bonds from the second quarter 2008 onwards. There have been good trading opportunities, such as recent days.  But in the main, gold lost investors money since it peaked in the first quarter of 2008. It has risen in European, Australian and emerging nation currencies, but has declined in yen. A hedge out of European and other currencies would have been far better had the choice been US Treasury and Japanese government bonds. Gold is a safe haven but is far more volatile than government bonds. It is a hedge against potential inflation following the massive increase in global money supply. Currently, however, the money is "pushing against a string" as debt deflation has destroyed tens of trillions of dollars of wealth.  The risk is that gold cannot be divorced from the current deflationary commodity cycle. Hence its indifferent performance during the systemic global financial crisis. Gold bulls were predicting prices well in excess of $1,000 an ounce, but so far it hasn't managed to surpass its March 2008 peak of $1037 an ounce. Gold's best chance is renewed dollar weakness, but then it might decline in other currencies.

Disclosure:- Marketpredict.com writers may have positions in securities, currencies, commodities and other instruments & assets from time to time. The article is for information purposes only and is not a recommendation to buy or sell (see disclaimer below).

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