Tuesday, 31 August 2010

Bond bubble- a sterile debate on semantics

Much ink has been spilt over the question of whether government bonds are in a bubble or not. The bond bubble believers love to cite stats along the lines that bonds are witnessing inflows at the same pace as equity funds did during the TMT bubble.












The bond lovers respond an asset with a finite life and no hope of limitless capital gain can’t really be a ‘bubble’, and beside they argue the ‘fundamentals’ warrant current valuations. (i.e. inflation is low and will remain so).

However, to me this is largely a sterile debate over semantics. The issue shouldn’t be whether bond are a bubble or not, but rather are bonds a good investment or not? Ben Graham defined “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative”.

Do bonds offers long term investors a sensible level of return? I’ve always thought that in essence bond valuation is a rather simple process (at least one level). I generally view bonds as having three components: the real yield, expected inflation and an inflation risk premium.

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 ten 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%.

The current 2.5% yield on the US 10 year bond is clearly a long way short of this. So unless you believe that Japan is correct template for the US (i.e. inflation will be zero for the next decade), government bonds don’t offer an attractive return as a buy and hold proposition.

Another way of looking at this problem is to ask how much weight the market is putting on a ‘Japanese’ outcome. Let’s assume three states of the world (a gross simplification, but convenient). In the ‘Normal’ state of the world bonds sit at close to equilibrium, say 4.5%. Under a ‘Japanese’ outcome yields drop to 1%, and under an inflation outcome yield rise to 7.5% (this assumes a 5% inflation rate).

The table below lays out my own estimates (kind of an agnostic view, with a prior biased towards the ‘Normal’ but cognizant 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. 

Bond Yield

JM Probabilities
Market implied
Normal
4.5
0.5
0.2
Japan
1
0.25
0.7
Inflation
7.5
0.25
0.1
Expected Yield

4.4
2.4

It is possible to build a speculative case for bond investment (i.e. riding the deflationary news flow down), however, as ever this leaves participants with the conundrum of  Cinderella’s ball  as described by Warren Buffett “The giddy participants all plan to leave just seconds before midnight. There is a problem though: They are dancing in a room in which the clocks have no hands!” Personally I prefer to stick to investment rather than speculation.

52 comments:

Jake said...

I think you have to look at an allocation to bonds at a portfolio level, rather than stand-alone basis, to make judgments of a market’s expected probability.

Why? What other asset classes provide positive returns IF (not when) the U.S. turns Japanese?

The answer (in my opinion) is... not many.

As a result, even if I personally believe in your .25 'turning japanese' probability, I am more willing (than you imply) to overallocate to bonds to improve expected returns at a portfolio level (i.e. the investment becomes a hedge for risk assets rather than expected return on a stand alone basis).

Example: Put return expectations for equities into the mix (my guess is if the U.S. goes Japanese, stocks will be damaged goods like they were in Japan), assign return expectations for long bonds given your target yields (assume ~8.5 years duration for a 10 year treasury and estimate how long it will take for the market to move to those levels) and "optimize" your portfolio's allocation based on the simple model.

I believe you'll find a much higher allocation to long bonds than when looking solely at treasuries.

John said...

These people don't even define what they mean by bubble except comparison to other "bubbles".

bb said...

i think there is something that many people seem to neglect as a fact: there is plenty of money that has to stay 'invested'. a bond fund cannot possibly go all cash, an equity fund can't either, hedgies are the same more or less, government agencies bond holdings are the same, petro dollar and asian treasuries holdings as well...
in such an environment, there is always a floor under demand and inflation matters much less than statutory requirements or executive decisions by politicians. when the search for yield is not the primary investment objective, any valuation is just fine.

Nisiprius said...

My reaction is... so? It's sucky, but how do I act on this?

I already know what my risk tolerance is, I'm not changing my stocks/bonds allocation.

I'm only interested if he has something to suggest that is clearly comparable to, say, Vanguard Total Bond Market Index Fund in standard-deviation risk, black-swan risk, and "bubble" risk--that equally clearly pays enough more to be worth the "veering-from-course" risk.

GestaltU said...

Hmmm. I'm not much for using very long- term averages in the context of 10-year time horizons, so the 2.6% number from the UK seems misguided. For reference, actual U.S. inflation (CPI), according to Shiller's database is 2.2% since 1870, but it suffers from the same long-term average vulnerabilities.

Fortunately, we can apply conditional probabilities rather than long-term averages to fund the market's best guess at future inflation. The Cleveland Fed has a model for expected inflation at terms from 1 through 30 years based on bootstrapped TIPS break-even rates and some other factors. It has an excellent track record (see their web page here. The current 10-year expected rate according to this model is 1.68%.

I am comfortable using the higher end of the range for the risk premium given current high levels of ambiguity, so lets say the risk premium is 50 bps. That brings the yield to 2.18% + the real yield.

The real yield is generally held to be an interpolated number, so it is difficult to apply an appropriate level. You haven't really addressed this in your post. As the actual Treasury yields are 2.46%, the implied real yield is about 28bps. I was taught that Treasuries are risk free, so the only premium we should pay is the inflation risk premium. I'd say 28 bps is north of zero, so I'll take it.

For posterity, I wonder how the same back-of-the-envelope analysis would have worked to value JGBs over the past 10 years or more...

"There is no such thing as a contradiction. Where you perceive that one exists, check your premises. You will find that one of them is wrong." - Ayn Rand

123 - themoneydemand.blogspot.com said...

James
I mostly agree, but the equilibrium level of real yield is now lower than long term average because of the Great Recession. We have a bond bubble, but it is a little bit smaller than you imply.

truthdoctor880 said...

I'm new to your website. Can you tell me: What's a TMT bubble?

Freestate said...

I agree with GestaltU and would go further. I think your probabilities have to be based on current conditions.

Surely the most important current condition has to be that we are in a post-crisis economic situation. And it seems to me that the Reinhardt and Rogoff research and then Reinhardt and Reinhardt research presented last week would be the starting point to establish the most relevant probabilities for possible outcomes.

As an aside to GestaltU, I have been using the Cleveland Fed inflation expectations until I read in the R&R paper that in these conditions inflation expectations have been too high in almost all situations they studied.

My main point here is that perhaps the biggest mistake investors make is to not use current conditions as the basis for their analysis. And James that is my main issue with your analysis. I think the probabilities are very different if you base them on current conditions.

I'm not saying that we are Japan or have to be Japan. I am just saying that today is obviously not 1992 and neither is it 1975. What are the probabilities given that we have disinflation and we are in a post-crisis economy? I think the R&R paper is the best source for the estimates.

Finally, it was a lot more entertaining when you were at SocGen and writing about the Ice Age thesis. I just re-read the Welling@Weeden interview with you and Albert from 2008 and it was great. It seems to me that the move to GMO has perhaps constricted your public views a little. A little bit more of the prior Montier would be awesome.

Andre Veloso said...

"The bond lovers respond an asset with a finite life and no hope of limitless capital gain can’t really be a ‘bubble’, and beside they argue the ‘fundamentals’ warrant current valuations. (i.e. inflation is low and will remain so). " Hahaha, have we just forgot about subprime bonds, or high-yield bonds, or... good luck!

Giles said...

Hello James,

I greatly enjoyed "the little book of behavioural investing", I am now reading "Value Investing".

With regard to the Analyst error study conducted by Rui Antunes, is there any chance that you could go into more detail? i.e. Was the average analyst error 95% over two years in Europe across all market cap sizes? Did the error differ with different market caps?

Also I am afraid, due to my own ineptitude, that I am not sure I completely understand what you mean by a 95% forecast error. Does this mean that an analyst forecasts earnings of £1 billion and two years later earnings are £50 million or £1.95 Billion? How does it work with negative earnings forecasts? If an Analyst forecasts a loss £1 million on a one billion pounds of turnover and the actual loss is £1.95 million, two years out that is an impressive estimate/guess.

In summary then, please can you go into more detail on this study. As I love the two year 95% error figure and I want to quote it all the time when people invoke analysts recommendations. However I need to be able to explain exactly how the figure works.

All the best,
Giles

invest said...

nice one!
UK investment

Sree said...

Dear James,

I want to ask you a question not regarding this article but something that you wrote some years back.

In the 'little note that beats the market' you had written that a simple P/E + ROA criterion outperformed the market over the long run.

Now in the actual book, Greenblatt suggests if you use something other than his actual formula then one should screen companies with ROA>25% and P/E> 5.

Did you do that when you used P/E+ROA criterion, or did you screen all the companies irrespective of the P/E and ROA and sorted them?

I would be grateful if you could reply,
as this would help me invest in a simple and effective way.

many thanks,

Sree.

John said...

1) The elite who organised and implemented stuff called credit cards, credit, debt etc. They knew it would implode, and now it has.

2) Bush, greenspan, bernanke are all part of the same boys club. They do not care about anyone but themselves. When we are screaming about high cost of things, then those in charge of the NWO will have us right where they want us. Time to prepare was yesterday.

Go have a look at http://www.forecastfortomorrow.com those guys have been spot on about the elections and what is coming very soon.

mike said...

The late Harry Browne developed a Permanent Portfolio that used 4, equally weighted, low correlated asset classes - the US long bond being one of them. The other three include physical gold, 1-3 yr US treasuries, and the sp index.
In this scenario, long and short term treasuries may make sense, if only for a balancing act. Rebalancing is achieved when an asset class is 10% above or below its 1/4 weighting. Since 1972 (the elimination of the gold standard), the portfolio has a CAGR of 9.7%.
http://crawlingroad.com/blog/2008/12/22/permanent-portfolio-historical-returns/

mike said...

There is actually a scenario where US Treasuries make sense in a balanced portfolio. The late Harry Browne developed a Permanent Portfolio that has a CAGR of 9.7% since 1972. It requires 4 equally weighted, low correlated asset of Long US Treasuries, Gold, 1-3 yr US Treasuries, and SP index. Only in this scenario where the treasuries act as a counter balance to the other components does it make sense. Rebalancing of the portfolio is achieved when one of the asset classes reaches a 35% or 15% of total weighting. Sometimes simplicity works.
http://crawlingroad.com/blog/2008/12/22/permanent-portfolio-historical-returns/

mike said...

opps sorry for the double post - more coffee needed.

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Adrian said...
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Adrian said...
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Adrian said...
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Adrian said...

James, in Behaviourql Investing you were very positive on Greenblatt's Little Method; how do you feel about it now? Many thanks and all the best, Adrian

F.R.E.E said...

Very informative post.

Unknown said...

Sometimes it's hard to decide which bonds are the quality ones to buy - a reason I like to stick with small cap trading. Have you looked into that much?

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Jason Prowd said...

Interesting post James. Any chance on a follow up post? Or have your duties at GMO precluded it?

Jason Prowd said...
This comment has been removed by the author.
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