US Bond Market - Meltdown in the offing?

 

After Nuclear disaster, is it now turn for a meltdown in Bond market? Investors are now bothering about another critical impending meltdown - grossly overvalued bonds, the most dangerous of all.

After the tech bubble in 1990s, followed by housing bubble in 2000s, it now seems to the turn of the bond market collapse, which when happens could be the most dangerous of all. If the bond market bubble busts, the unavoidable and direct consequence is that interest rates will surge — not only on bonds, but also on mortgages, auto loans, business loans, and nearly every kind of financing possible.

A recent report, from the research firm headed by New York-based University Professor Nouriel Roubini who rightly predicted the sub-prime housing bust and subsequent financial crisis, predicts that debt defaults of local and state government (grossly overvalued bonds in the US) could rise 650% in 2011. Moreover, the dreadful disaster that has just hit Japan fades the shaky US Treasury Bond market moderately as it holds a major chunk of US bonds. Analysts anticipate that quake-hit Japanese economy will not only bring to a standstill the US treasury bond purchases by Japan, but it will also force the authorities to make substantial sales of a significant portion of their reserves of the US treasury bond to finance the enormous cost of stabilization, reconstruction and restoration of the economy.

The US government fiscal situation is worsening as deficits have topped $1 trillion, the highest levels when measured since World War II. It is too big for the current bond market and there are hardly enough investors to purchase the ever growing US government debt. This is the reason why the US Federal Reserve recently purchased $600 billion of debt to keep interest rates on the debt at a reasonable level. If not, the US debt would become more toxic and less attractive to the investors who still hold the US t-bonds. The PIMCO Total Return Fund, top mutual fund decided (prior to the earthquake) to sell off all of its US Treasury holdings in exchange for corporate bonds as yields on treasury bonds are too low, especially with the risk of inflation growing each day.

Roubini doesn't think that defaults in the municipal market will lead to any of systemic problems for the US economy that happened when the sub-prime mortgage market meltdown. According to Dr Doom, many of the bonds that go bad won't be worthless and local governments will make good on around 65% of their bad debts. The unrated bonds that could default are generally smaller issue bonds that back specific projects like roads or water treatment centers. Though defaults on this type of bonds are not common but in the past there were many instances of defaults.

The bottom line

Investors are worried that amidst unparalleled spending by the US government, the Federal Reserve will inevitably increase interest rates which in turn reduce the value of existing treasury securities (generally bond prices fall when interest rates rise and increase when rates drop). The billion dollar question that investors are debating is – is the end of a treasury bull market that began in the early 1980s around? With inadequate investors to fund the growing deficit, the US will have no choice but to cut hundreds of billions of dollars from federal spending in 2011, or else it may run out of money very soon which would in turn trigger bond market to crash.

 

N Janardhan Rao, Senior Economist.