Bond not such a safe haven and are heading for a spectacular fall when interest rates rises, according to a leading fund expert

News - Banking

Written by Ray Clancy

Friday, 10 September 2010 09:32

Bond yields are falling to unseen levels for generations, experiencing a sustained period of low inflation and risking a bubble, it is claimed.

When interest rates rise the recent rally in bonds will unwind ‘spectacularly’ as they are being seen as a safe haven and investors are hiding behind them and ignoring valuations, a leading expert believes.

The situation means that pension and life funds have become forced buyers and as yields decline they are forced to purchase more bonds, as they discount their liabilities by a smaller number, therefore perpetuating a vicious cycle, according to James Foster, fund manager of the Artemis Strategic Bond Fund.

‘Bond markets are assuming a sustained period of low inflation or even deflation, and a double dip recession. This explains why bond yields are falling to levels unseen in generations,’ he said.

He believes that the bond market seems to be ignoring one salient fact, that is that governments are throwing everything at finding a solution. ‘Monetary policy has been loosened even more by recent extra bouts of quantitative easing in the US. Though it is being tightened somewhat in the UK and Europe, fiscal policy is still very slack. Meanwhile commodity prices are rising, and inflationary pressures are building,’ explained Foster.

‘In the UK, Bank of England governor Mervyn King’s obligatory writing to the Chancellor, to explain the failure to keep inflation down, has reached embarrassing levels. Today’s policies will inevitably lead to inflation,’ he added.

‘We are reaching bubble territory, with bonds offering a negative real yield. That makes no sense. People are hiding in bonds as a supposed safe haven and ignoring valuations. Bubbles can last for some time, of course, but we know that when they burst it tends to be dramatic,’ he warned.

Foster thinks that the situation cannot go on. ‘The catalyst will probably be some acceptance that interest rates will have to rise. When that happens, expect the recent rally in bonds to unwind quite spectacularly,’ he added.