The bond bubble still has room to grow

Over the course of the Fleming’s 12 novels and the 22 James Bond movies (the highest grossing series ever at $4.9 billion), Bond utilizes his astute intelligence gathering capabilities, combined with various gadgets, including an exploding attaché case, to save the world from a myriad of threats. If Bond were a research analyst studying today’s markets, the U.S. bond markets may be considered an emerging epidemic in his analytical purview.

Even if not an epidemic, bond issuance levels this year have been staggering. Firstly, in the municipal bond market in the United States, as of May, issuance is up 70% compared to the same period in 2011. Secondly, in the U.S. corporate bond market issuance is up 5% year-over-year, but has seen a serious acceleration in the last few months with investment grade issuance up 54% and high yield up 30% in July 2012. Finally, according to Lipper Research, bond ETFs have seen the eighteenth consecutive month of net inflows.

So, is there is a bond epidemic/bubble? Given the stance of the global central banks to keep interest rates at artificially low levels, it is likely not an epidemic that is going to end in the short term. In fact, we are actually aggressively allocated to U.S. government bonds as we think equities are at an extreme and growth is continuing to slow. Certainly though, James Bond, the research analyst, would be gathering his intelligence and watching and waiting for an opportunity to sell the high yield bond market.

MORE: Why I’m not buying the “equities are dead” argument

As we show in the chart below, which we have aptly named, From the Central Banks with Love, the high yield market is at a generational low in yield. Obviously when studying a corporate bond, there are a number of factors to analyze in determining whether it is overvalued or undervalued. Certainly, the overall interest rate environment is critical, but ultimately the prospects of the company are the drivers of a junk bond’s value, especially given the bond’s inferior position in the capital structure. Therefore, given that yields in the junk bond market are literally at generational lows, it implies that default risk is also close to an all-time low. Personally, I’d need a few James Bond-esque martinis before I’d believe that last point to be an accurate assessment of default risk.

Speaking of bonds, Der Spiegel reported this weekend that the ECB may set a specific threshold to cap periphery bond yields at its meeting in September. The immediate reaction in the European sovereign debt markets is, not surprisingly, positive as credit default swaps are trading tighter across the board. As well, the Spanish 10-year is back down to 6.19%. Even if positive in the short term, broad intervention in a large market speaks to another epidemic — the epidemic of government intervention in the free markets. Random intervention by governments does not build confidence in the markets. And confidence is what is sorely missing in the European debt markets.

In the latest sign that global growth is slowing, the Shanghai Composite hit a fresh three and a half year low yesterday morning. The Chinese equity markets may not always garner headlines in the U.S. financial media, but nonetheless China remains the engine for global growth and as China goes so goes marginal global growth. Thursday will give us some important insights on Chinese and global growth as flash PMIs are reported for China, Europe and the United States.

Follow Daryl Jones on Twitter @HedgeyeDJ