Value Investing: Tools and Techniques for Intelligent Investment

Chapter 29. Bonds: Speculation not Investment^[29]

It isn't often that Albert and I find ourselves on opposing sides of an investment debate. However, the current state of the government bond market has us divided. From my perspective as a long-term value-oriented investor, bonds simply don't offer any value. They already price in the US slipping into Japanese-style prolonged deflation. However, they offer no protection at all if (and it may be a big if) the Fed can succeed in reintroducing inflation (what Keynes described as the 'euthanasia of the rentier'). There may be a 'speculative' case for continuing to hold bonds, but there isn't an investment case.

• To my mind, in principle, government bond valuation is relatively simple. I see the value as the summation of three components: the real yield, expected inflation, and an inflation risk premium. The market tells us that the real yield for 10-year US government bonds is around 2%. Given that the nominal yield is also around 2% at the moment, the market is implying that inflation will be around 0% p.a. over the next 10 years.

• This suggests that the market believes that the USA will follow the Japanese path into slow grinding deflation. Unravelling the forward curve shows the market expecting 10y bonds to yield 3% in 10 years time! Surveys of long-term expectations show a different picture – they suggest that inflation will be around 2.5% p.a. over the next 10 years. This implies a radically different pricing of bonds. In a normal ...