The Globe and Mail

“Bond bubble.”

Not only does it have a nice, alliterative ring to it, but the concept seems to satisfy a morbid need on the part of a certain segment of the financial community. These skeptics remain convinced that the markets haven’t yet purged themselves of the chronic infections that brought on the tech bubble and the U.S. housing bubble, and so they sit patiently, almost longingly, for the next asset bubble to blow up.

And the bond market makes an easy target for them. Prices for U.S. and Canadian government bonds have soared far higher and for far longer than many pundits had expected, leaving interest rates on those bonds wallowing at near-record lows – and yet investors keep on buying. When you get to such dizzying heights, it’s hard not to glance over the edge and notice how very far down it is should you slip and fall.

But is the fall inevitable? Does this really qualify as an asset bubble?

John Riley thinks so. And not just because of the massive, seemingly unshakeable flood of investor money into bonds, but because that flood has created a market where the risks now far outweigh the rewards.

The bond-buying frenzy

“Bubbles all have the same story on the way up,” said Mr. Riley, founder and chief strategist of U.S. money manager Cornerstone Investment Services LLC, in a recent report. “They seem perfectly logical to the investor.”

Yet the numbers surrounding the bond rally suggest that at some point, hysteria has overtaken logic.

“More money went into [U.S.] bond funds in 2009 than went into stock funds at the height of the Internet craze in 1999-2000. More money has gone into bond funds in 2009 than in the previous 19 years totalled,” he said.

What’s more, it isn’t slowing: 2010’s bond-fund inflows are on track to match or even surpass 2009’s total.

No pay for play

“One of the key reasons the previous bubbles collapsed was because the investor wasn’t being compensated appropriately for the risk they were taking,” he said. “Internet stocks had little to no earnings and residential real estate generates no income at all.”

So the key question, then, is whether the bond market is adequately compensating investors for the risks of buying bonds.

On the surface, U.S. government bonds are pretty low-risk. There’s a guaranteed yield and a repayment of the principal portion of your bonds if you hold them to maturity. The risk of default may no longer be near-zero in the wake of the global debt crisis, but it’s still infinitesimally small.

However, Mr. Riley said, “interest-rate risk” is potentially massive.

He said that if the U.S. 30-year bond yield were to rise to a relatively modest 5 per cent within the next year (a level it approached a mere six months ago), that would equate to about a 20-per-cent decline in the market price of the bond – which was paying investors an interest rate of just 3.75 per cent when Mr. Riley penned his report earlier this month.

“The gain is only 3.75 per cent, versus a loss of 20 per cent,” he said.