Should Bond Investors Brace for a 1994-Style Crash?

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The recent run-up in sovereign bond yields combined with a recovery in global growth could lead to a crash in bond prices similar to the one seen in 1994, said investment house AMP Capital in a report published Thursday.

According to investment strategy head Shane Oliver, the strong bull run seen in the sovereign bond market last year was fueled by concerns of a global recession, prompting investors to hide in safe haven assets.

But now investors are growing more confident, and speculation over interest rate hikes could push bond yields higher leading to steep losses for bondholders.

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"A new worry is that bond yields, after falling for years, will shoot higher as central banks start to tighten and investors switch to shares - causing losses for bonds and threatening other assets," said Oliver.

Yields on 10-year U.S. Treasurys, Australian 10-year government bonds and British 10-year gilts all fell to record lows last year of 1.39 percent, 2.8 percent and 1.44 percent , respectively. Treasury yields have now recovered to 2 percent, but are still low compared to historical levels.

Oliver drew parallels between today's markets and the early 1990s, adding that yields are lower and investor exposure to sovereign bonds is greater in comparison to 1994.

"In the early 1990s bond yields were pushed down by recession, falling inflation and then a jobless recovery. However, the cycle turned aggressively in 1994 after the economic recovery became well entrenched in 1993," he said.

The U.S. Federal Reserve raised interest rates from 3 percent to 6 percent starting in February 1994, while the Reserve Bank of Australia raised the cash rate from 4.75 percent to 7.5 percent over four months from August 1994.

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"This saw 10-year bond yields rise from 6.4 percent to 10.7 percent in Australia and from 5.2 percent to 8 percent in the U.S., which saw Australian bonds generate a loss of 4.7 percent in 1994," said Oliver.

Furthermore, the rise in yields did not only affect the bond market but also pressured equity markets, which lost 8.2 percent in Australia in 1994 and returned only 1.3 percent in the U.S., according to the AMP report.

Getting 'Bubbly'

Evidence of "bubbly elements" in today's market, according to Oliver, include investors getting too accustomed to low interest rates, together with the false perception that past returns equal future returns combined with overvaluations in the bond market.

"Bonds are very overvalued from a long term perspective. On this basis, bond yields are well below long term sustainable levels. This suggests that bonds are vulnerable if sentiment towards them changes," he said.

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Fixed income portfolio manager at UTI International Viral Bhuta, agreed talk of a bubble forming in the sovereign bond market has been heightened in recent months.

"When interest rates are low people always start talking about bubbles. The problem is there needs to be a catalyst - such as a rapid rise in interest rates - to trigger the bursting of the bubble," said Bhuta.

According to Bhuta, a sudden plunge in U.S. unemployment rate below 6.5 percent prompting the Fed to raise rates, could prove to be such a trigger. "Yes, this might be the early stages of a bubble but I don't see it bursting anytime soon," he said.

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Meanwhile, Ashley Perrott, head of pan Asia fixed income at UBS Global Asset Management, said a 1994 style crash in the bond markets can never be completely ruled out, but was not too likely in the near-term.

"The lower yields go the more chance of a crash there is. It doesn't take much of an upward yield shift to produce negative returns when you're coming from such low levels," said Perrott. "But today's environment is different from 1994 because back then a 3 percent hike in interest rates by the Fed happened within a year prompting the crash. We are a long way from there."