Fixed income: Bond bubble blues

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Demand pressure weighs on fixed-income market.

Fixed-income investors enjoyed a great run in 2012 – and given that those returns were driven almost entirely by central bank policies that are unlikely to change, they must be feeling pretty happy about 2013 as well.

Since the markets collapsed in 2007, around $10 trillion of central bank liquidity has been pumped into the global financial system and there have been more than 450 interest rate cuts around the world. Despite this, we can expect more of the same.

However, investors still merrily piling into bond funds should have pause for thought. Between 2006 and 2012, yield on the aggregate fixed-income index has fallen from 534 basis points to 170bp and duration is now approaching all-time highs. Indeed, volatility in 10-year US treasuries is now higher than in equities.

As Rick Rieder, chief investment officer of fixed income at BlackRock, pointed out in December, this extension of duration creates the illusion of safety. With a current duration of 20 years, it takes only a 15bp increase in 30-year rates to wipe out an entire annual yield. This could trigger losses at a lot of those investors that have piled into the bond markets of late.

Investors spent much of 2012 worrying about whether they were in a credit bubble and will probably spend the beginning of 2013 doing the same thing. There might not be an excess of supply in credit but there certainly is an excess of demand.

Some argue that bubble conditions are not present, as there has not been a frenzy of re-leveraging. But given the volumes of cash on corporate balance sheets that they stubbornly refuse to invest in growth, that is hardly a surprise. So the key question is: what will it take to trigger investors to move out of bonds and back into equities again?

Although not enjoying the noisy boom that there was in credit, the equity market was no laggard last year. The S&P500 was up 13%, the DAX up 27% and the Euro Stoxx up 11%.

Central bank actions during the past year have bought the markets time, and the threat of inflation still appears some years away. After years of policy easing, low real rates and deleveraging, the fixed-income markets will continue to shrink unless growth returns, and the demand-supply imbalance in the market will persist.

Against this backdrop, the pendulum of sentiment might begin to swing the equity market’s way this year.