The Coming Bond Crisis

Part of my speech was devoted to the current state of world bond markets. Bonds are the kind of investment which most personal investors do not have in their own personal names, but anybody with superannuation will almost have part of their money in bonds. When times are challenging, they are often called a “safe haven”, but as you read on you will find this is far from the truth.

Bear in mind, that I am talking about government bonds, not investment bonds which are tax paid investments just like your superannuation.

Anybody who owns a bond has an investment which is normally for a fixed term, with interest payable on a regular basis, and the capital value paid in full on maturity. For example, if you bought an Australian $100,000 – 10 year government bond today you would have a promise from the Australian government of a capital return of $100,000 in 10 years and interest at 1% per annum for as long as you kept it. In my view, that’s a lousy return, but those who like bonds claim the big benefit is that your capital is guaranteed by the government. But don’t forget, that $100,000 you will receive in 10 years will probably buy much less than it would buy today.

Now, the thing about bonds is that their market value increases as interest rates drop. Obviously, if I have a government bond paying 4% per annum, and rates drop to 2% per annum, the value of my bond will rise, because 2% has become the current going rate, and my bond is paying 4%. So, in the last 10 years as interest rates have gone down and down and down, bonds have had a bull market. For the for the last year, European bonds have returned 9%.

But those days are gone. Most government bonds in Europe are now yielding negative returns, but under European law pension funds are forced to invest in them. Therefore, fund managers are investing heavily in bonds which they know they will lose money on.

It is my view that interest rates cannot fall much further in Europe. Once rates reach negative territory savers are penalised for having money in the bank, and, as I pointed out in a recent newsletter, home borrowers in Denmark are now having their mortgage payments paid to them by the bank instead of them paying them to the bank. Obviously, rates must be close to bottom, which means they will either stay where they are, yielding a tiny negative rate, or start to rise again.

Here’s the crunch – the moment rates start to go up, bonds will enter a bear market and their values will tumble. The pension fund managers in Europe will be stuck with owning financial instruments with a negative interest rate, at the same time as the capital value is falling. It will be a bloodbath.

So what are the alternatives? The old favourites; cash, property and shares. The Reserve Bank dropped interest rates again today, which means cash is yielding next to nothing. This leaves us with property and shares, which I think should do well if a bond crisis happens. The bonds will not become worthless, because there is still a guarantee of the capital value of maturity, but some of these are over 100 years.

The thing about property, is that it has a sense of permanence, which should increase in value it was in the right location, and good quality. It should also continue to produce a good income from rents.

Now think about shares – when you own a share, you are owning part of a business. Even if there was a bond crisis, the businesses in whose shares you own should still prosper, and keep paying you dividends. This is why I think the good property and good shares will continue to do well provided you stay in there for the long term.

Just remember we are in uncharted waters. Make sure keep enough cash on hand for three years planned expenses.

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