Why bonds are scaling new heights

News Analysis: Surging bond markets are erasing memories of the crash four years ago. It's hard to find anyone who feels it won't last
THE BAD bout of nerves attacking global financial markets has some very distinct symptoms. While equity markets are suffering from feverish ups and downs (in the US and Europe) or are simply down in the doldrums (in Asia), bond markets are powering from strength to strength. The yield on the benchmark long-term US Treasury bond has fallen to a whisper above 5.6 per cent, the lowest since it was first issued in 1977.

More generally, bond markets are displaying the highest prices and lowest yields in 30 years. The gap between bond and equity yields which opened up in the late 1950s has not yet been reversed, but it has narrowed in the past 10 years and is now closing faster.

It is a signal that investors have fundamentally rerated bonds relative to equities for the first time in a generation. The question - especially for anybody scarred by the memory of the bond market crash at the start of 1994 - is whether it will last.

The tentative answer seems to be yes. Whereas opinions are sharply divided on the outlook for the Dow and the FT-SE, it is hard to find any analysts who are pessimistic about prospects for bonds. Trevor Greetham, global strategist at Merrill Lynch, says: "I'm very bullish about bonds. I much prefer bonds to stocks." Kevin Adams of Barclays Capital says: "In terms of the relative risks, the real danger is a correction in world equity markets."

The recent annual report from the Bank for International Settlements, banker to the world's central banks, sets out the reasons for this overwhelming bullishness about bonds. The first is the world-wide fall in inflation this decade. For the most part, independent central banks in the developed economies have achieved the best inflation performance in recent memory. The rediscovery of the benefits of low and stable inflation after the turbulence of the late 1960s to late 1980s has been helped by a period of weak commodity prices and the disinflationary impact on the world economy of the crisis in Asia .

A second seismic shift in economic policy has been the shrinkage in government budget deficits. Most governments have got religion about the need for fiscal prudence.

Both the US and UK are likely to see shortages of government bonds up for auction this year. Last year the US government sold just $18bn worth of new debt and this year it is expecting its first budget surplus for three decades.

At the same time, demand for bonds is rising for fundamental long-term reasons - the ageing of the population in developed economies, and the maturing of pension funds. The baby boom is now saving hard for its old age, and institutional investors are putting a higher share of these funds into bond markets rather than more risky equities.

Merrill Lynch/Gallup's regular survey of fund managers shows that bonds are very popular with the institutions. The most recent survey of views, taken earlier this month, shows not only that UK fund managers are heavy buyers of gilts, but also that these fund managers are buying overseas bonds at a rate not seen since the survey was launched in 1990. "It boils down to the most basic law of economics: supply and demand," says Mr Adams.

Mr Greetham agrees. "You're in a situation where there's plenty of liquidity and money has to find a home." According to Mr Greetham, because the world-wide economic slowdown is pressurising corporate profits, money is going into bonds, not stocks.

With these multiple reasons for bond markets to go from strength to strength, are there any risks on the horizon? The most obvious hazards are a reversal of investor sentiment about how well inflation has been tamed, and a liquidity shock.

Mr Greetham says: "Bonds are basically all about inflation. If an inflationary spiral started to appear somewhere, that would upset the bond markets." Inflationary fears can also be sparked by growth, Mr Greetham added. "If you see growth globally, yields would tend to increase as people worry about the effect on inflation."

Yesterday's disappointing inflation figures in the UK certainly set back the gilts market, although mainly at the short-term end of the yield curve. The markets would be more vulnerable still to bad news about US inflation, on which there were also disappointing figures yesterday.

The US Federal Reserve has shifted towards a "bias to tighten". In other words, it has put the financial markets on alert that short-term interest rates might have to rise to keep the lid on inflation - despite the turbulence in Asia's financial markets.

Although the apparently omnipotent Alan Greenspan, the chairman of the Fed, has started to prepare the markets for the possibility of a rate rise, a particularly bad set of inflation figures would certainly jolt bond markets world-wide.

The greater risk, perhaps, is that the flow of funds into key bond markets, especially the US, might go into reverse. As the BIS puts it: "There would be a possibility of large sales of US securities in the event of liquidity crunches elsewhere."

The traditional fear is that the shrinking capital base of the Japanese financial system would force Japanese investors to repatriate funds from the US despite the dismal returns they would get at home. In addition, the Japanese government might liquidate its holdings in order to sell dollars and buy yen if it needs to stabilise the currency.

US Treasury Department figures show that Japanese holdings of its bonds have in fact started to shrink in the past 12 months. However, so far other foreign investors have more than taken up the slack, and Britain has overtaken Japan as the principal overseas investor in the US Government.