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A Global Bond Rally With Grim Tidings

Daniel Kruger and Anchalee Worrachate

Mohamed El-Erian knows why bond markets from the U.S. to Germany and Japan have seen yields drop to record lows even after outstanding debt has ballooned. “We may be in a synchronized slowdown,” says El-Erian, chief executive officer of Pacific Investment Management Co., the world’s largest bond manager. “We could stay here for awhile.”

The credit markets are signaling tough times ahead. Yields on government securities in the U.S., Germany, the U.K., the Netherlands, and Australia tumbled to all-time lows this month as Europe’s debt crisis intensified and unemployment in the U.S. unexpectedly rose.

The average yield on bonds issued by Group of Seven nations (Canada, France, Germany, Italy, Japan, the United Kingdom, and the U.S.) has fallen to 1.23 percent as of June 12, from 3 percent in 2007. Germany’s two-year note yield fell to less than zero for the first time on June 1, while Switzerland’s has been negative since April 4, meaning investors are paying those nations to hold their money.

Those rates imply that bondholders don’t expect global economic growth to exceed 3 percent this year, according to John Lonski, chief economist at Moody’s Capital Markets Research Group. In comparison, the global economy expanded at an average of 4.7 percent in the five years before the financial crisis took root in 2008. “As far as developed economies are concerned, the credit market is coming to the conclusion that real economic growth will be slower than what we’ve become accustomed to since the Second World War,” says Lonski.

The slowdown matches the prediction by El-Erian in 2009 for a “new normal” in global economies characterized by a slower pace of expansion, higher unemployment, and a greater role for governments in private markets.

Gains in the bond market have come even as supply has expanded which, all things being equal, would depress bond prices and increase yields. The Bank of America Merrill Lynch Global Broad Market Index now tracks debt issues with a face value of $40 trillion compared with $23.9 trillion in June 2007, and up from $15.3 trillion in June 2002.

Some of that new supply is being bought by central banks, including the Fed, the European Central Bank, and Bank of Japan, as policy makers purchase government securities in attempts to bolster their economies. The holdings of the world’s six biggest central banks have more than doubled since 2006 to $13.2 trillion, according to Chicago-based Bianco Research. Financial institutions are also buying government bonds as they seek to increase their capital to meet regulations set by the Basel (Switzerland)-based Bank for International Settlements.

In recent months, bond investors have been rewarded by falling yields. Since March 20, when the 10-year Treasury yield peaked at 2.4 percent, U.S. government securities have returned 3.7 percent, with benchmark 10-year notes gaining 7.2 percent, Bank of America Merrill Lynch indexes show. The MSCI All Country World Index of stocks declined 10 percent over the same period.

With rates so low, buying government bonds is not likely to deliver similar profits anytime soon. Investors from Leon Cooperman, founder of hedge fund Omega Advisors, to Warren Buffett, the chairman of Berkshire Hathaway, have said investors should avoid bonds. Bond yields at current levels are not sustainable and investors should buy stocks instead, says Marc Faber, author of the Gloom, Boom & Doom Report. “The government bond bubble will also burst,” Faber said in a June 7 interview on Bloomberg Television. “I don’t know whether it’s going to be tomorrow or in three months. But I suspect that it will happen sooner rather than later.”

Other analysts say the strong demand for bonds shouldn’t be compared to the housing boom or the mania for Internet stocks. “You’re not talking about a bubble because a bubble is about greed,” says Jeffrey Rosenberg, chief investment strategist at BlackRock. The bond boom is “not a reflection of ‘I expect prices to go higher and I have to jump in,’” he says. It’s “a reflection of ‘I want to preserve my principal.’”

Stuart Thomson, a money manager at Ignis Asset Management in Glasgow, discounts the possibility of a sudden spike in rates that would inflict big losses on bondholders. “Yields are extremely low for a very good reason, and that’s fear,” he says. “History suggests in an environment of extreme risk aversion, yields will go down in an elevator but go up on an escalator.”