2013 Bond Market Forecast: Is the Bond Bubble Finally About to Burst?

[Editor's Note: Here's a question that has vexed investors for years now. Everyone says rates have nowhere to go but up and all they have done is fall. According to Shah, this actually could be the year the bond bubble bursts.]  

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The Federal Reserve's multi-year prescription of targeting super-low interest rates on federal funds, along with various quantitative easing programs, has pushed yields down on all fixed-income instruments to the benefit of issuers and the detriment of investors.

There is little doubt that the Fed's articulated and executed policies have resulted in a bond-bubble with both short and long-term consequences for investors and the economy.

At some point the bond-bubble will burst. But there is no certainty on when that will happen or what ultimately will cause rates to rise.

What investors need to understand is that while yields and bond prices in 2013 could remain flat relative to closing third quarter 2012 measures, yields are unlikely to fall further and prices are unlikely to rally in 2013, with the possible exception of short-term U.S. treasuries.

However, there is the possibility of what I'm calling a "skyfall."

For fixed-income investors this means there is a chance the bond bubble may finally burst.

2013 Bond Market Forecast: From Flat to Skyfall?

Skyfall is the title of the latest James Bond film, which viewers discover is also the name of Bond's childhood home in Scotland, before it is blown apart in the movie's climactic finish.

Now, because interest rates across the board have fallen to historically low levels, the great bond rally could suffer a similar climax.

Here's where we stand now, why the bond rally is likely over, what could happen in 2013, and what early warning signals to watch for to get out of the way of this skyfall.

As yield-hungry investors have plowed more and more money into bond mutual funds, bond ETFs, and, for institutions, individual bonds, issuers from sovereigns to junk dealers have rushed to the market to soak up the trillions of dollars searching for yield.

That circuitous path has kept money flowing into bonds in search of falling yields as issuers take advantage of low rates artificially manipulated by the Fed's actions.

All dollar-denominated bonds issued in the United States (and many issues globally) are priced off the U.S. Treasury yield curve.

That's the scale of interest rates that starts with the federal funds rate (even though the Fed doesn't issue fed funds) and displays the interest rates payable on Treasury bills, notes and bonds, up to and including the most actively watched, traded and talked about 10-year T-bond, all the way to the 30-year T-bond.

Treasury issues are considered "risk-free" because they are backed by the full faith and credit of the U.S. to pay all interest and principal on its debts.

All other bonds yield more (pay more interest) than equivalent-maturity Treasury issues to reflect the difference in "quality" between a Treasury issue and a municipal, corporate, or other bond issue.

The difference between what a Treasury's yield is for a particular maturity bill, note or bond and what the yield is on another issue is called the "spread."

The spread refers to the additional yield (the difference in the interest rate) issuers have to pay to attract investors who otherwise might opt for the safety of Treasuries.

As interest rates have been kept artificially low, investors looking for additional yield above exceptionally low-yielding Treasuries have been increasingly willing to accept smaller and smaller "spreads" when they buy bonds that aren't risk-free.

Issuers recognize investor demand for yield and know investors will still buy their bonds even as they offer less and less interest, because whatever yield advantage investors can get, they will gladly take.

As a result, the spread over Treasuries has come down for all issuers from top-rated investment grade issuers to leverage bond and junk issuers.

In other words, investors are not being adequately compensated for the increasing risk they are taking with issuers, who range from investment-grade corporations to special-purpose vehicles issuing junk bonds for leveraged and speculative endeavors.

The Fed's recent announcement that they will buy $40 billion per month of top-rated agency paper (mostly mortgage-backed-securities), only takes even more U.S. government-backed paper out of the market, leaving investors clamoring even more for whatever investment-grade ("IG") bonds they can get. That's a further boon to bond issuers.

In fact, in just the third quarter of 2012 (the latest quarter for which data is available) IG issuance, excluding sovereign, supranational, split-rated and preferred-stock issues, exceeded $215 billion — a near record.

But that's IG. What's more telling, and evidence of how much investors are reaching for yield further out on the risk spectrum, is what third-quarter issuance was in the leverage and high-yield (junk) markets.

Leverage loans are loans and bond issues backing loans to corporations, companies and other issuers that already have high leverage on the debt side of their capital structure. High yield, also known as junk bonds, are debt issues offered by the most speculative issuers seeking debt financing.

Leverage bond issuance totaled $114 billion in Q3, a record, which included a constituent record $20 billion issued in August, historically the year's slowest month.

At the current pace, with $317 billion already issued year to date, leverage loans are on track to reach $423 billion, or exceed $508 billion if September's $63.5 billion pace continues.

And while the leverage loan market has been flush, the high-yield market has been doing its own hot issuance thing.

Bond-clearing yields fell in the third quarter to all-time lows, even though spreads are still above record lows. High-yield issuance in the third quarter was $91.9 billion, the second highest on record. The highest quarter ever was this year's first quarter at $99.9 billion. Full-year 2012 junk issuance is closing in on the record $287 billion issued in 2010, and likely to exceed it.

Combined leverage and HY issuance in all of 2012 is expected to exceed $748 billion, topping the former record of $679 billion reached in 2007.

We Know What Happened Next….

With rates so low and investor appetites still high, we're seeing more and more "covenant-lite" deals, the ones that afford more protections to issuers than to investors.

Investors need to look through the froth in the bond market and realize that a lot of bonds are issued with call features and are in such demand that they are trading at premiums to par value, or what will be returned at maturity.

It's imperative that investors realize that coupons, or the interest rate that a bond comes to market with, is different than what you will get on a yield-to-maturity basis if you pay a premium, or especially if you pay a premium and the bond is called long before you expect to have held it.

With prices so high and yields so low, all relative to the risk of holding bonds in a bubble-like market, investors need to have an exceptionally strong stomach to wade into the bond market now or in 2013.

Investors also need to beware of false rallies.

The risk-off trade, where equity investors flee to the safety of Treasuries, could make Treasury prices rise and bonds look like a safe haven. They could be, for a while.

Then there's the outside threat of inflation that would cause rates to rise and bond prices to plummet. Or the move to the risk-on trade, which would signal that equity investments are preferred to the low-yielding safety of bonds, which could decimate bond prices.

Or there's the chance that the economy double-dips in 2013, putting pressure on leverage loan and high-yield issuers to make interest payments at the same time that investors flee their bonds and raise capital structure costs for them.

I'll be watching the derivatives markets, namely the credit default swap indexes like CDX-IG-19 to see if default insurance costs start rising, by how much, how fast, and on which indexes.

I'll leave a light on for you, and shout out loud here and in my services if the bond vigilantes start gathering at the end of town.

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About the Author

Shah Gilani is the Event Trading Specialist for Money Map Press. He provides specific trading recommendations in Capital Wave Forecast, where he predicts gigantic "waves" of money forming and shows you how to play them for the biggest gains. In Short-Side Fortunes, Shah shows the "little guy" how to make massive size gains – sometimes in a single day – by flipping large asset classes like stocks, bonds, commodities, ETFs and more. He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.

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  1. db | November 30, 2012

    The problem is that similar arguments have been made for the past 4 years. Details change but the basic argument remains the same.

    What makes NOW different?

    • Paul M. | December 2, 2012

      People said the same thing about people who started predicting the collapse of the housing bubble in 2005. When it finally happened in 2007, most were still caught off-guard.

  2. Edouard D'Orange | November 30, 2012

    I wish that more people would read your well reasoned columns.

  3. H. Craig Bradley | November 30, 2012

    COMPLACENT AND GOING NOWHERE

    Former Republican Presidential Candidate Mitt Romney forecasted in 2011 that we could experience a "bond market crisis" sometime in the middle of an Obama second term. That would be about 2014 by my calendar. So, if correct, investors should not continue to add to their long or intermediate bond investments, but instead should reduce their positions and go to cash.

    Others predict we are headed for recession in 2013. Either way, its more and more uncertainty and the only asset that seems to thrive on uncertainty is gold. Stock indexes have been in a trading range for the last four years or more. VIX is pretty low and indicates investor complacency. Voters who reelected President Barack Obama in view of average GDP growth of 2% certainly were complacent. Mitt Romney was the archtype complacent Republican presidential candidate, as well.

  4. Beate Biehn-Blank | November 30, 2012

    Please, isn't it somewhat logical that if I buy 10-year bonds in 1999 they mature in 2009, if I buy them in 2003, they mature in 2013… If I inherit 10-year matured 10-year bonds in 1999, it depends very much on when they were purchased on a global level which was not very much there at the time, in financial matters, at least for the ordinary globally thinking citizen. – The claims are the actual bubbles, as I see it from different angles, depending on whether there are actual entitlements to those claims or people riding the waves on those who allegedly have it all. Please evaluate as I as I can only tell from my global experience and background and research into the matters of a family that has a history to date, like anyone else, too. – Correct me please, if I am wrong. There is definitely a need to appease these uprising crowds to come to their senses again with hope for a future.

  5. Curtis Edmark | December 1, 2012

    The low bond yields create another investment problem that is rarely talked about. Investment advisers who charge a fee for managing clients assets typically show disdain for traditional stock brokers who charge a commission for each trade, and even more disdain for insurance agents who market fixed life and annuity products also for a commission. Many of them believe they are so far above that because the recommendations they make "are based on what's best for their clients whereas these other representatives recommendations are based on what pays the most commission." The reality is the low bond yields potentially create an ethical dilemma for investment advisers who charge a fee. The problem is: How do you convince a client to pay you 1% per year of the assets you are managing for them if you steer a portion of their money into bonds which are only paying 2-4% before you assess your fee? Could this factor cause an investment adviser to steer their clients into riskier investments which potentially pay a higher return because that is the only way they can convince their clients to pay them the 1% per year?

    • Ethan | December 3, 2012

      Nice article, I'm a financial planner and have been for 10 yrs now. Sorry if the writing is a little sloppy, I prefer numbers. I started doing IA business a few years ago so maybe I don't share some of the characteristics as others but I don't have distain for commission business, I still personally do a lot still. For me when it comes to choosing between a commission account and an IA account is all comes down to fees to the client. A few reps and I have sat down and really crunched the numbers many times to see when a client should go into an IA account. Depending on there risk level it changes a little but a general rule of thumb is when they have around 125,000 in assets. If you have a balanced portfolio that is never moved the IA fees will catch up to the commission fees in year five. I explain this to my clients and tell them if they would like to stay with one family of funds or be able to move free among many managers. Most of the time they pick the IA account. I haven't been doing this for long time but have see a big shift in the industry to reduce cost, provide liquidity, and flexibility. This can be achieved a lot cheaper for the client in an IA account. I do though come across a lot of accounts that clients bring in from other brokers that are in a IA account, all in the same family, well under 100,000, and they haven't moved in many years. I see all of the new regulations that have come in to "protect the client", but they are all at the fund level. There needs to be more regs but down on reps to make sure they are doing their job if they are getting paid every year to just do nothing.

  6. Curtis Edmark | December 1, 2012

    The low bond yields create another potential problem for investment advisers who charge a fee for their advice. How can you convince a client to pay you 1% per year of the assets you manage for them if you steer a portion of their money into bonds paying only 2-3% before you charge your fee? Could this force investment advisers to steer a higher percentage of their clients' assets into higher risk investments because they offer better potential returns?

  7. Curtis Edmark | December 1, 2012

    Never forget the age old axiom: What goes up must come down!

  8. Curtis Edmark | December 1, 2012

    How does an investment adviser charge a 1% annual fee to a client if they steer some of their money into bonds paying 3% or less? Could this force them into recommending higher risk investments because those investments offer greater potential returns and thus will enable them to convince their clients to still pay them 1%?

  9. Robert Harris | December 1, 2012

    For a while now, we have been hearing that there is going to be a huge crash in the bond market. I agree. But like any other crash, many of us can see it coming; we just don't know when. These days, whenever there is a problem anywhere in the world, there is the so-called "flight to safety", where the panic-stricken head for US Treasuries. I have a feeling that one of these flights to safety will be the spark that will crash the bond markets.

  10. james | December 6, 2012

    I have a mortgage that adjusts in mid 2014 I understand the rate will be tied to what happens in the bond market is there a good way to understand what the rate might be or how quickly it will rise if there is a major change in the bond market?

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