The bond bubble question. Back to this.
The latest entree into the debate comes from James Montier of GMO (via FT Alphaville)who writes on his blog that the whole premise of the debate is nonsense. Why? Because it doesn’t matter if it’s a bubble or not. The question is: Are bonds a good investment in the current environment.
First, he posts this chart of bond fund inflows (comparing them to the tech/media/telecom bubble of 2000), as the es-sense of why people think there’s a bubble.
But onto the real question of whether bonds make for a good investment…
The real yield can be measured in the market thanks to inflation-linked bonds. In the US, a 10 year Tip is trading at just under 1%. Expected inflation can be assessed in a variety of ways. We could use surveys, for instance, the Survey of Professional forecasters shows an expected inflation rate of just under 2.5% p.a. over the next decade. In contrast, the nominal bonds minus the TIP yields implies a figure of more like 1.5% p.a. The inflation swap market is implying a 2% p.a. inflation rate over the next 10 years.
The inflation risk premium (a risk premium to compensate for the uncertainty of future inflation) is generally held to be between 25bps and 50bps. Given the uncertainties surrounding the impact of monetary and fiscal policy I’d argue that using the high end of that range seems reasonable. Using these inputs a ‘fair value’ under normal inflation would be around 4%. Of course, this assumes that the current market 1% real yield is itself a ‘fair price’. This seems like a questionable assumption to me. In the UK we have a longer history of index linked bonds – introduced in 1986. The average yield since the introduction is 2.6%, in the last decade the average real yield has been 1.5%. Given this ‘parameter’ uncertainty is would be reasonable to say that ‘fair value’ for 10 year bonds is somewhere in the range of 4-5%.
So in other words, 10-year yields are a garbage return… unless you’re betting on the Japan outcome, which is a possibility of course.
So how do you weight that?
The table below lays out my own estimates (kind of an agnostic view, with a prior biased towards the ‘Normal’ but cognisant of the other two risks), then bond should yield around 4.4%. I can then tinker around with the probabilities to generate something close to the market’s current pricing. In essence, the market is implying a 70% probability that the US turns Japanese.
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