As bonds continue to yield historically low levels of return many are driven to wonder if there is in fact a distortion in the bond market driven by fears of a collapse in the equity markets. The ongoing struggles of the European Union, coupled with the United States’ debt burden and the possibility of a contraction in China have driven investors toward bonds as a safe investment alternative.
The severe lows in yields of those bonds considered safe, most notably German and US bonds, appears to many to be lower than it should be, even in straitened circumstance. Some new research into the effects of “economic disasters” on asset prices seeks to reassure traders about the soundness of the current market.
Germany is the most interesting “safe” bond market. Despite having sound economic fundamentals, the country is tied up in a European project facing large risks on the periphery. Germany’s risk of defaulting is not low by itself, but a slew of defaults across the continent could force its hand in any number of ways.
The United States is two steps removed from that, the most profound risk in the world economy at present. Germany does not have that same remove. German bond holders therefore at a much greater risk of losing money if a disaster occurs. The question is whether German bonds are actually overpriced, and whether or not Angela Merkel and Co. can do anything about it if there is.
An economic disaster is a severe and sudden contraction in economic in a region being studied. Numerical definitions of such events vary widely. These events have only recently become important to economists and analysts in studying the movement of the economy. Much of this research supports the argument that the current circumstances in the bond market are the results of natural and accurate pricing, rather than a bubble or other aberration.
In a disaster the larger than normal risk involved in equity trading means that investors will flock to bonds and cause their prices to fall to extraordinarily low levels, perhaps even below inflation. As risk of default in certain bonds becomes greater there is higher level of correlation between bonds and equities. This phenomenon can be seen clearly today in the peripheral European countries.
Even as the risk of default increases across the board, some bonds are still seen as safer in a bond market collapse than equities would be. Analysis performed by large financial institutions estimating the effect of a Eurozone break up would be an average of a 10% fall in GDP across the Union. The effect of such a collapse on asset prices could mark the most rigorous test the international bond market has ever faced.
A key assumption of this model is one common in economics investors seek to level out their incomes across future yields. Asset investment is used for two separate functions, it is a store of value and therefore insurance and against loss, and assets provide a stream of future income.
Viewed in this light, of attempting to level future income in all years, bonds are by far the most valuable asset available to most investors. Their safety in ensuring the existence of future income, despite the default risk, is much greater than those of equities, even when equities are offering reasonable returns.
While this argument, taking into summation the effects of disaster risk, could be seen as a neat method for explaining the prices of bonds offered by the United States, it is not quite as clear why Germany should be facing the same level of default risk, though it lies at the heart of default country.
10 year German bonds currently yield about 1.32%. That is so low that any number of scenarios could result in a complete wiping out of the value of these assets. If disaster does strike Europe and there is a worst case scenario messy Eurozone breakup, the resultant drop in GDP along with currency confusion could result in any number of outcomes for German bonds.
is very little Angela Merkel’s government can do about risks such as these right now, bar developing a detailed plan for such a situation. Such a plan would of course raise worries about the future of the entire continent, and the world economy, precipitating disaster rather than nullifying it.
Angela Merkel’s really cannot do anything about the value the market currently puts on the country’s bonds. Ensuring there are no unstructured defaults inside the Eurozone, and keeping a lid on the disaster, as she’s been attempting to do for the last three years, is all that can be done.
It is up to the market to put a correct value on bonds. Despite the weight disaster analysis puts behind the current price levels, the value associated with German bonds still appears to be too high. Investors need to take this into account.
It does not appear that there is a real and sustained bubble in German bonds, but there is some overpricing when the risks associated with any European bond are taken into account. Investors should certainly be wary of this particular investment, and reevaluate the risks despite the relatively solid price point US Treasury Bills sit at according to the disaster theory.