The Global Government Bond Bubble Enters The Final Blow Off Stage

What's taking place right now with government bond prices around the world is well beyond anything we have witnessed in the history of the financial markets. We have reached the absolute climax of the greatest government debt bull market run in history. This absolute rock solid confidence behind the paper governments issue is over 80 years in the making, and the coming rise in bond yields will shake every corner of the earth. 

Before we take a look at some of the astonishing bond yields, let's have a broad common sense discussion about bonds. The intrinsic value behind a government bond is the ability of the sovereign taxpayer to pay back that debt, plus interest, in the future. 

In comparison, a stock or corporate bond's intrinsic value is the company's ability to pay back the debt, plus interest, or continue paying dividends in the future. There is something real and tangible behind the asset. It is only when the economy slows or confidence behind paper corporate assets fall (usually reflected with price declines) that people begin to remember and think about the intrinsic value of a stock or corporate bond. 

In 2003 we wondered how investors in 1999 could possibly purchase Internet stocks with no strategy in place to generate revenue growth at P/E multiples in the 300's and up. It was rising price momentum combined with rising confidence that removed any concern of risk within the asset. 

The same applies with real estate. If you are buying mortgage debt, REITs, or a commercial building, there is a physical piece of real estate that generates cash flow to pay off the bond interest or pay dividends in the future. It is only when real estate markets turn down and the confidence behind real estate paper or the building's value declines that people begin to remember and think about the intrinsic value of a real estate investment. 

In 2009 we wondered how investors in 2006 could possibly purchase subprime mortgage bonds backed by homeowners who had annual income lower than the monthly mortgage payments, poor credit and no assets. It was rising price momentum combined with rising confidence that removed any concern of risk within the asset. 

Fast forward to February 2015. Government bond yields have been in a steady uptrend (falling yields) for over 33 years. Decades ago investors combined future inflation expectations with the risk of default to determine a rational rate of return needed to risk their capital in sovereign debt. Today those risks are forgotten or ignored. 

The following are three risk factors that should be considered when making an investment in a government bond:

1. Inflation

Inflation determines your real rate of return in a bond investment. If a bond yields 1% and inflation is running at 2%, then you are losing 1% per year in purchasing power by investing in the bond. In other words, your investments returned 1% for that year but your monthly bills rose by 2% so you're running in quicksand. 

2. Risk of Default or Devaluation

Anyone with a calculator and understanding of simple arithmetic can quickly determine that many of the governments around the world will never be able to pay back the money they have borrowed (and plan to borrow) without massive devaluation of their currency. This will occur through their central banks printing money to purchase their sovereign bonds. If central banks do not step in, governments will be unable to pay interest on the debt and/or default. Either scenario means investors will lose their money directly or lose the purchasing power behind the money they invested. 

3. Opportunity Cost

If you have $100,000 tied up in a government bond that yields 1% per year you must factor where else that money could be used to receive a better return. Perhaps it is an investment in a better performing stock, bond or commodity. It could be used to start a business or purchase a piece of real estate that generates income. 

Let's now briefly take a look at the price investors are paying for government bonds today and then discuss reasons why they are purchasing them at these insane valuations. 

Here is the 10 year yield for German government bonds which have fallen from 2.0% in July of 2013 to 30 basis points (0.30%) entering the weekend. This means if you lend money to the German government they will pay you 0.30% per year on your investment for 10 years. At the end of 10 years they will give you back your principal. 

French 10 year government bond: 54 basis points (0.54%). Traded at 2.6% in July of 2013. 

Japanese 10 year government bond: 29 basis points (0.29%). Traded at 1.0% in early 2013. 

My personal favorite, the 10 year government bond in Switzerland, where you must now pay the Swiss government to loan them money for 10 years (-0.30%). Yes, you read that correct. If you lend them money, you must pay them interest every year for 10 years because the bond yields are negative. 

Switzerland is not alone in the world of negative rates. $3.6 trillion of government debt traded with a negative yield last week around the world. This number fell to less than $2 trillion by the end of the week because a large portion of Japanese government debt just (barely) moved back into positive territory (think 0.01% instead of negative). Truly incredible. 

In comparison to these ridiculously low yields, the 10 year on the U.S. treasury looks like a bargain at 1.63% (the record low is 1.40% reached in July 2012). It was at 3.0% entering 2014. Here's a quick summary of other 10 year yields around the world:

Canada: 1.25%

Britain: 1.33%

Italy: 1.59%

Spain: 1.41%

Hong Kong: 1.28%

Singapore: 1.86%

It makes no sense for a rational individual investor to own some of these bonds (but most are invested heavily in them through mutual funds). Why? They can just park their money in a government insured savings account with a 0.0% return and not have any of the principle risk involved with purchasing a 10 year government bond at 0.30%. 

However, if you manage an enormous sovereign wealth fund with trillions of dollars under management you must find a large liquid home for the money. Bank accounts guarantee deposits up to $250,000 in the United States so that is not going to help a Chinese sovereign wealth fund that needs to park $2 trillion. This problem is compounded as central banks continue to pump a relentless stream of liquidity into the financial markets through quantitative easing; the money needs to find a home. 

Investors buying these bonds at these yields are not looking at them like a 10 year investment, they are looking at them as a short term flip where they can receive capital gains through appreciation. Banks and hedge funds can borrow money at close to 0.0% and leverage it up ten times in the futures market to purchase German government bonds at 0.30%. If yields fall to 0.15% they will make a large capital gain on the purchase due to the leverage. 

What is the problem? Just as with flipping homes in cities around the world in 2006, at some point the last greater fool is going to enter the market and prices will finally peak. Then as leveraged trades begin to unwind you will see speculators rush to the exits while yields begin to rise (bond prices begin to fall). 

No one anticipates this process to become disorderly due to the misguided belief that central banks are in control of bond prices, but I can almost assure you that it will be. When prices begin to fall at the peak of the bubble (think of a movie theater catching on fire), investors will not calmly walk to the exits.

People will look back at this bond bubble mania with the same exact wonder they did with tulip bulbs in the 1600's and Pets.com in 1999. 

I will have much more to write about this topic in the coming weeks because I think we are close to the historical inflection point. I will discuss what the bursting of this bubble will mean to investors, individual countries, financial markets, other asset prices and the global economy because all will be severely impacted by this paradigm shift. Just as with real estate in 2006 this bubble is global and the consequences will make 2008 look like a warm up for the main event.