Bond market to borrowers: Pay me back in 100 years

Markets Associated Press

Italy has suffered through bouts of inflation and a revolving door of failed governments in the past 50 years, so you would think it would have to offer a super-high interest rate to entice people to lend to it for the next 50. But in a bond sale last month, it got away with just 2.85 percent, half the rate it paid for a three-month loan a few years ago.

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Bond investors are supposed to be rewarded with higher interest rates in exchange for investing in riskier borrowers, as well as for waiting longer to get their money back. They appear to have forgotten that this year.

They're lending to Ireland not for 50, but 100 years, and at 2.35 percent. They've handed $1 billion to Disney for 10 years, at a rate — 1.85 percent — barely above inflation.

The Japanese, Swiss and German governments are demanding more money upfront for their bonds than investors will ever make back in interest — guaranteed money losers. Yet many investors are actually buying them, figuring they'll be able to sell the bonds to others at an even higher price and make a profit.

These so-called negative yielding bonds now total $12 trillion around the world, up from basically zero two years ago, according to Bank of America Merrill Lynch, and have crept into popular bond funds held in 401(k)s.

"It's a crazy situation," said Miami money manager Richard Lehmann. "The relationship between yield and risk is totally out of whack."

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Whether all this ends in a bang or whimper is dividing Wall Street.

The whimper camp thinks low yields are not so crazy because inflation will stay low and so won't eat much into the purchasing power of fixed bond payments. Your portfolio may not do well, but it won't be the source of the next financial crisis.

Investment banker Daniel Alpert says rates would be super low even without the efforts of central banks because the global economy is growing slowly and there is simply too much of nearly everything — workers, factories, oil, metal and, most importantly, cash, which people are hoarding and putting into bonds instead spending on things.

"Everyone is writing, 'Watch out for inflation,'" says Alpert, managing partner of Westwood Capital. But there is "no evidence of sustained inflation."

The bang side thinks yields have sunk too far even given low inflation, the result of an experiment by central banks to stimulate their economies by buying trillions of dollars of bonds. When ordinary investors come to their senses and start dumping their holdings, they may find few buyers and prices will plunge, possibly taking with it stocks and other assets as people sell all manner of things to stay solvent.

Paul Singer, head of giant hedge fund Elliott Management, told his investors this summer that the bond market is a bubble, the largest in history. The famed "Bond King," Bill Gross of Janus Capital, calls the market a "supernova" ready to explode.

We may soon find out who is right. Bonds have been falling off and on for weeks now on signs of a pickup in inflation in some rich countries, and a possible pull back in central bank buying.

The problem is not just that loans are being extended at low rates, but the sheer volume of them. In the eight years after debt spiked on the eve of the 2008 crisis, families, companies and governments took on another $69 trillion, a jump of 53 percent, according to the latest figures from the McKinsey Global Institute.

With so much money flooding the lending markets, things have gotten sloppy.

In 2013, a company in Mozambique raised $850 million from global investors to buy a fleet of tuna boats though the company had formed just a few months earlier. These "tuna bonds" have since lost a third of their value amid allegations of misuse of the funds and a sinking Mozambique economy.

Emerging markets like Mozambique are particularly vulnerable. Half of their debt has been dubbed "junk" by rating agencies, the most risky category, and companies there have loaded up on a particularly dangerous kind. They have more than $1 trillion in U.S. dollar denominated bonds outstanding, double the level from before the 2008 crisis, according to the Bank for International Settlements. Now that the dollar has soared in value, companies that do business in local currencies have to sell more to pay their bond investors back.

Rich countries may be vulnerable, too.

Money manager Lehmann says European banks holding low yielding government bonds could face steep losses should the market turn and they decide they need to sell them along with everyone else. Lehmann has been predicting trouble for years so it's not clear a bond implosion is coming soon — if at all.

But investors hoping to unload absurdly valued bonds for even more absurd prices should be careful. Those 50-year Italian bonds that everyone was clamoring to buy last month are sinking fast, down 7 percent in two weeks.

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Bernard Condon can be reached at http://twitter.com/BernardFCondon.