I was recently asked by a fund management trade association to write an analysis of why there was such a dramatic boom and bust in equities. I started by discussing why stocks rose so high.
As an order of magnitude, share prices rose to twice the level that was reasonably justified at the end of the 1990s. The TMT sector rose to more like four times the justified level.
Sell-side analysts tried to explain this by pointing to a projected acceleration of corporate earnings growth. But this never happened; in fact, earnings fell.
The question now is whether something similar has happened in bonds. After all, since the March 2000 peak in equities, the aggregate total return in dollars of the JP Morgan Global Government Bond Index has reached 33 per cent, mostly since early 2002.
As in the equity boom, the biggest recent gains have been concentrated in some of the riskiest sectors, such as high-yield corporate bonds. These have delivered a total return of 19 per cent in the first half of 2003, while emerging market bonds have returned 36 per cent over the past 12 months.
Following the pattern in equities, the bond bubble has been aggravated by narrow benchmarking and trend-chasing. The emphasis is on short-term total returns rather than long-term risks.
As the Bank for International Settlements commented in its annual report last week, banks have improved their credit risk management, partly by shifting risk into the bond market.
The justification for the bond boom is said to be the threat of deflation. Indeed, falling prices would bring a bonus to bond yields by adding an extra real return. But it remains to be seen whether deflation proves to be any more of a real event for bonds than the corporate profits boom was for equities.
In any case, deflation would surely be compatible with a widening of credit spreads rather than the narrowing that we have seen in recent times.
Modern pension fund management seems to be dogged by relentless momentum effects. There is an absence of countervailing flows from major market participants ready to rebalance across different asset classes on the basis of consistent valuation methods. Instead, focused bubbles and anomalies are generated.
Yet some fund managers are determined to retain control over the top-down agenda.
Mr James Foster, a prominent bond fund manager at ISIS Asset Management in London, has surprised investors (and probably his marketing director) by warning of a bubble in some of his own bond sectors. Investors, he said, should switch to equities.
On the website of Pimco, the US bond giant, Lee R Thomas has just put out a similar message. "You cannot rationalise long-maturity bond yields where they are today," he says. "Sell bonds."
Certainly there has been a sharp sell-off in bonds, with 10-year government bond yields jumping by about 40 basis points since mid-June on both sides of the Atlantic.
This is a correction intensified by the failure of an apparent bet by bond market players that the US Federal Reserve would cut interest rates by 50 basis points on June 25th. The peak coincided with some provocative new issues. For example, General Motors' $13.5 billion (€11.9 billion) blockbuster to plug a hole in its pension plan (not the kind of motivation normally favoured by the bond market). There was also the UK Treasury's opportunistic move to exploit, through a 2¼ per cent dollar bond issue, what it viewed as an anomalous bubble in the US fixed income market.
Modern marketing methods attract vast sums into the latest high-returning assets. The UK unit trust sector has been dominated this year - for the first time - by net inflows into corporate bond funds.
The purchases have been made largely by intermediaries.
For most fund groups, the response is to retrain - or hire - some bond managers and launch a range of focused products, just as technology equity funds were being created in large numbers in the late 1990s.
The problem is that investors are likely to wind up being the losers and will become disillusioned with an investment industry that peddles illusions. A lot of the bubble tendency can be blamed on the policies of the Fed, going back to the early 1990s. Cheap money is pumped into the system, and imbalances are not corrected but are perpetuated.
Even now, there are hopes in the dollar bond market that the Fed will reinvigorate the bubble by buying long treasuries and cutting its overnight rate.
For the fund management industry, the problem remains that its appetite for volatility is greater than that of most of its clients. - (Financial Times Service)
