Thursday, August 19, 2010

Will T-Bond Investors Go Bust?

Last month Jim Gust noted Jeremy Siegel's opinion that stocks are undervalued – way undervalued. Now, in The Great American Bond Bubble, Siegel and Jeremy Schwartz warn fixed-income investors to run for cover:

Ten years ago we experienced the biggest bubble in U.S. stock market history—the Internet and technology mania that saw high-flying tech stocks selling at an excess of 100 times earnings.***

A similar bubble is expanding today that may have far more serious consequences for investors. It is in bonds, particularly U.S. Treasury bonds. Investors, disenchanted with the stock market, have been pouring money into bond funds, and Treasury bonds have been among their favorites. ***

We believe what is happening today is the flip side of what happened in 2000. Just as investors were too enthusiastic then about the growth prospects in the economy, many investors today are far too pessimistic.

The rush into bonds has been so strong that last week the yield on 10-year Treasury Inflation-Protected Securities (TIPS) fell below 1%, where it remains today. This means that this bond, like its tech counterparts a decade ago, is currently selling at more than 100 times its projected payout.

Three decades ago inflation was running rampant and Treasury bonds were considered terrible investments. (Wouldn't you like to own 12-percent T-bonds now?) Could inflation pick up and turn today's mini-yield Treasuries into disastrous investments?

Chances of a recovery strong enough to rev up inflation seem faint. In another WSJ op-ed, The End of American Optimism, Mortimer Zuckerman seems to consider the Great Recession a normal downturn but does acknowledge one structural change:
The relationship of household debt to income has proven unsustainable. The ratio is normally established somewhere below 100%, but in 2007 the debt ratio hit 131% of income. It has now fallen to 122%, but at this pace it would take another five years to bring it under 100%. The pre-bubble norm was 70%. To get to this ratio again, debt would have to be reduced by about $6 trillion.
Siegel and Schwartz retort that the Great Deleveraging won't be all that great a drag on the economy:
Today the purveyors of pessimism speak of the fierce headwinds against any economic recovery, particularly the slow deleveraging of the household sector. But the leveraging data they use is the face value of the debt, particularly the mortgage debt, while the market has already devalued much of that debt to pennies on the dollar.
They may have a point. Look at home-equity loans, where the delinquency rate is worse than for credit cards.

Jim Gust's skepticism that stocks are cheap seems sensible. That doesn't mean Siegel and Schwartz are wrong about a Bond Bubble.

How much would you put into 30-year Treasuries?

Related post: The Year the Stock Market Died

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