The bursting of the bond bubble, and why Ken Henry is wrong

Ken Henry suggests super investors pile into bonds. We couldn't disagree more.

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Ken Henry suggests super investors pile into bonds. Here at The Motley Fool, we couldn't disagree more.

You could have knocked us over with a feather.

Our old pal Christine Lagarde, head of the International Monetary Fund (IMF), has gone all soft…

"…the world economy has stepped back from the brink and we have cause to be more optimistic."

This is the same person who just a few months ago said the world economic outlook "is quite gloomy" with pervasive downside risk, and the world was facing "a 1930s moment, in which inaction, insularity and rigid ideology combine to cause a collapse in global demand".

Seems like we're not staring at a Great Depression after all. How things can change…all in the space of 3 months.

Next up Ms Lagarde will be telling us to pile into stocks, although based on her recent track record, she'll likely give that advice after markets have jumped another 20 or 30 per cent.

Oops. Missed the best first quarter rally in 14 years…
Over in the U.S., the S&P 500 has rallied 12 per cent this year and is on pace for the best first quarter since 1998. We hope you weren't spooked out of the market by Ms Lagarde's dire warnings.

Mind you, she's not the only economist guilty of adding to the general hysteria and panic at the bottom of the sharemarket. More than any other profession, they are guilty of looking through the rear view mirror, extrapolating the recent past deep into the future.

Even Ken Henry is guilty. The former Treasury secretary is urging superannuation investors to reduce their exposure to shares and increase bond holdings.

We've no problem with the suggestion that investors diversify, particularly as they get older. It would be foolish (with a small 'f') for an 80 year old to be fully invested in shares.

But bonds? Now?

The bursting of the bond bubble
"Global bond markets have enjoyed a three decade long bull rally," said Mansoor Mohi-Uddin of UBS on Bloomberg. "But this era is now set to end."

Bonds are not risk-free assets. As interest rates increase, the price of bonds falls. And in the U.S. especially, with interest rates at effectively zero per cent, and the economic recovery slowly but surely building momentum, the only way for interest rates is up.

Back in January I made a prediction that the yield on U.S Treasuries will rise over the next three years, meaning the underlying asset will fall in value.

I even put my own money on the line, setting up a short position on the iShares 20+ Year Treasury Bond Fund ETF (AMEX: TLT) by selling naked call options.

My prediction, and my investment, is off to a decent start – year to date, the ETF is down 9 per cent, a massive move for what is effectively a bond fund.

A no-brainer risk-free investment
Here in Australia, the interest rate situation is vastly different to most of the rest of the Western world.

Our cash rate is 4.25 per cent, and banks like Commonwealth Bank of Australia (ASX: CBA), National Bank of Australia (ASX: NAB) and Suncorp Group (ASX: SUN) are falling over themselves to offer up to 6 per cent interest in instant access bank accounts.

Why invest in risky bonds when you can earn a risk-free 6 per cent interest rate?

The flip side to our high interest rates is the handbrake effect they are having on our own sharemarket.

Whilst U.S. markets are soaring, trading at their highest level since May 2008, and within 10 per cent of their October 2007 record high, by comparison the S&P/ASX 200 index is floundering.

We're light years away from our October 2007 high of 6,750. Today the S&P/ASX 200 trades at just under 4300.

This is no time to throw in the towel
Still, as you would expect, we're not about to throw in the towel. Quite the opposite, in fact.In our most recent update to Share Advisor subscribers, Investment Analyst Dean Morel said…

"Right now, we continue to find excellent opportunities in the market, and as long-term buyers of shares, we'll continue to put our money to work."

Glenn Stevens joins the War
We'll close with some comments from another of our old pals, Reserve Bank of Australia Governor Glenn Stevens.

Regular readers may remember we thought the RBA would cut interest rates in February. Mr Stevens and his merry men surprised us, and many others, by keeping them on hold.

Well done to the RBA. The call was probably right. Mine was wrong.

So, with my newfound respect for Glenn Stevens, it was very heartening to see him join our War on Pessimism…

Whinging Aussies
As reported in The Age, he said structural change brought on by the high dollar had fed a "sense of concern in some parts of the Australian community, and the tendency to focus on the difficulties rather than the opportunities".

It reminds me of BHP Billiton (ASX: BHP) CEO Marius Kloppers' answer to a question from Alan Kohler on the ABC's Inside Business…

"Alan, I'm a little concerned that your last three questions all started with the word problem. The way that I look at it is that there may be an opportunity here…"

Why worry?
Some may call us blind optimists. We like to think of ourselves as being realistically optimistic.

Where some look for problems, we look for solutions. Where some worry about what might go wrong in the future, we focus on what might go right.

Onwards and upwards. Progress and profitable investing opportunities wait for no Fools.

Attention: Are you worried about a sharemarket crash? Click here to read a free Motley Fool report titled "Read This Before The Next Market Crash. The report is free, and reading it now could save you thousands of dollars, and lots of heartache.

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Bruce Jackson is The Motley Fool's General Manager. Bruce has an interest in BHP, CBA and NAB. You can follow the Motley Fool on Twitter @TheMotleyFoolAU. The Motley Fool's purpose is to Help The World Invest. Better. This article contains general investment advice only (under AFSL 400691)

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