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An employee crosses the lobby of the Athens stock exchange (LOUISA GOULIAMAKI/AFP/Getty Images)
An employee crosses the lobby of the Athens stock exchange (LOUISA GOULIAMAKI/AFP/Getty Images)

Where are the bond vigilantes? Add to ...

Mere months after Greece found itself on the brink of default and leaders throughout the developed world warned darkly that bond vigilantes would brutally punish other governments that failed to rein in ballooning deficits, the supposed advocates of fiscal discipline in the bond world are nowhere to be seen.

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Billions of dollars have poured into U.S. Treasuries, Japanese government bonds and other debt issued by more financially challenged governments, driving down yields to historic lows and driving out short-selling skeptics foolish enough to be on the wrong side of one of the market's hotter trends.

"A lot of the talk of vigilantism came from people who extended what happened in Greece and said it was bound to happen in the U.S. or Britain or elsewhere," said Arthur Heinmaa, managing partner with Toron Investment Management in Toronto. "If vigilantes were truly out there, they would have been clocking the U.S. bond for months on end. But any significant selling has never materialized."

Indeed, the government bond market has been flooded by retail investors seeking what they consider a safer harbour than stocks for their investment dollars. U.S. bond funds have posted net inflows for 72 of the past 73 weeks. according to data compiled by EPFR Global of Cambridge, Mass. The bulk of that money has been earmarked for government issues, including municipal debt.



"Something called the economy got in the way [of the vigilantes]" said David Rosenberg, chief economist and strategist at Gluskin Sheff in Toronto and a noted bond bull.

Federal Reserve policy and the inflation outlook are far more important for predicting the direction of bond yields than fiscal policy, Mr. Rosenberg said. "Where the bond vigilantes went awry, they were just running a one-variable model."

Not surprisingly, bear funds designed to score from falling Treasury prices have been hammered as a result, in one case falling as much as 40 per cent so far this year.

"Anyone who believed the stuff about invisible bond vigilantes, and acted on it, has lost a lot of money," Nobel-winning U.S. economist Paul Krugman wrote on his blog this week.

But as recently as June, Japanese Prime Minister Naoto Kan invoked the spectre of the vigilantes, a mysterious community of investors said to be clamouring for iron financial discipline in calling for strong fiscal medicine.

"We cannot sustain public finance that overly relies on issuing bonds," the Prime Minister told parliament. "As we can see from the euro zone confusion that started in Greece, there is a risk of default if growing public debt is neglected and if trust is lost in the bond market."

Since then, Japanese bonds have soared. And such other debt-laden countries as Spain have seen a resurgence of demand, taking the yield on Madrid's 10-year benchmark bond down by nearly a percentage point to 4.16 per cent in less than two months. Yet neither Spain nor most other governments have made a significant dent in their deficit spending.

But that doesn't mean it might not become a problem on the turn of dime, warned Dylan Grice, global strategist with Société Générale in London.

"I wouldn't take it as evidence that there's no problem because the market is telling you that there's no problem," he said. The risks of another credit market disaster remain.

"You could easily see a scenario where the bond market suddenly blows up," Mr. Grice said, "It could happen in three months ... or five years. There is no way to predict. But this is a major fault line which is very, very well developed."

Banks remain the largest holders of government debt, so if the bonds were to plunge in value, the financial system could quickly end up back in a 2008-style crisis.

Mr. Grice's conclusion: Government bonds are risky investments in this environment. And the idea that they are somehow risk-free is a remarkable delusion.

Still, he would not bet against them. "It's suicidal. Bond markets are overvalued. They can become more overvalued. I wouldn't short them because of a long-term solvency issue."

Meanwhile, ordinary investors remain convinced they will be much better off in bonds than stocks if and when the next economic storms hit.

"Baby boomers have lived through two 50 per cent market crashes and they are just leaving [equities]rdquo; in the mistaken belief they can do better in bonds, Mr. Heinmaa said.

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