The trinity of rising interest rates, large government debt and inflation is spooking investors out of traditional safe havens, such as sovereign bonds.
Traditionally, bonds are issued by governments or corporates as a way of raising money.
Interest is offered to the investor with a set date on the return of the money (maturity).
With Governments around the world on a spending spree, many commentators are concerned about the explosion of the sovereign bond market, and questioning whether there will be a bond bubble.
Bubble history
A quick walk down recent bubble history reveals the tech stocks blow-out in the late 1990s, followed by the credit and real estate crunch in 2007, after which panicky investors quickly moved into traditional safe havens, such as bonds and cash.
Anne Anderson, Head of Fixed Income at UBS, said bonds achieved stellar double-digit returns in 2008; the UBS composite returns were 14.95 per cent, eclipsing hedged international bonds, which returned a healthy 9.21 per cent for the same period, reports Morningstar.
In comparison, total returns for the UBS composite in 2009 was 1.73 per cent while the UBS Bond fund returned 3.36 per cent, and cash was around 3 per cent.
Ms Anderson expects Australian yields in 2010 to increase moderately as monetary policy is tightened - albeit much is already anticipated in bond market prices.
Still popular, but buyer beware
In the first ten months of 2009, bonds were still popular with investors, who ploughed in an extra USD $313 billion into US bond funds, reported Christopher Van Slyke from US Smart Money magazine.
Regarding 2009, BlackRock's Global Fund expert James Holt said: "Investors were pouring money into bond funds based on past performance."
But bonds are still subject to volatility, and the current bond euphoria may fall off, leaving many investors disappointed.
Investment guru George Soros describes bonds as a potential bubble if recovery and inflation return.
However, Anne Anderson does not describe US sovereign bonds as a 'speculative bubble'.
"While there is fiscal strain on economies, such as Greece and the UK this is reflected in relatively higher yields in these countries.
Generally, bond yields in developed nations are low because cash rates are close to zero, economies are very weak and inflation is low - I don't see that as speculation".
"It's good investment practice to have some diversified fixed income exposure as this provides regular income streams, liquidity and stability", she adds.
But even though there may be a bubble in bonds, a significant correction would not be as catastrophic as an asset bubble burst in equities or property.
Bond prices to go down?
The bond market vigilantes are putting pressure on US and UK authorities to reduce the large budget deficits or risk another financial crisis.
But the rise in inflation and interest rates would force bond prices down.
As the economy picks up, interest rates rises are already evident in the US and Australia. The issue for central banks is whether inflation can be contained.
However, growth is still sluggish in the UK and the Euro zone despite massive deficits and emergency measures by the central banks.
"The jury is still out on the ultimate impact of these policies," James Holt says.
"We prefer shorter term bonds because these are less sensitive to rises in interest rates."
He added there's a renewed demand for US Treasury Inflation Protected Securities (TIPS), which fared extremely well in 2009, returning +11.4 per cent.
Protection against inflation?
Inflation-linked bonds may be one way of protecting against inflation, Holt says.
But Tim Bond of Barclay Capital argues that "It's a no-brainer to have no bonds in your portfolio, certainly no government bonds."
Barclay's argument, reported in the Financial Times in mid-February, is that equity and bond returns since the 1920s have largely been driven by demographic trends, such as the 35-54 year old age group in global populations, and the number of retirees.
Now that the boomer generation are drawing down savings, we are moving from a world of capital abundance to a world of capital scarcity, says Bond.
"We are forecasting disastrous returns from government bonds. The chances of real return over the next decade are extremely low", he says.
And while sovereign bonds are under threat, investors holding high-yield corporate junk bonds in the US are racing for the exit with over US 1 billion withdrawn from US funds last week (up to February 15) - the largest outflow in almost four and a half years, as reported by Lipper FMI.
Anne Anderson says the withdrawal from high-yield junk bonds is through investors taking profits. These type of bonds delivered fantastic returns of 57.7 per cent last year while US Treasuries delivered - 3.6 per cent, and investment grade corporate debt delivered 16.6 per cent.
And high grade corporate bonds are still sought after by investors, she adds.
Ready to pounce
BlackRock Global Allocation Fund is also holding a high cash allocation and ready to acquire cheap assets when the time is right, says Holt.
While the sovereign bond market outlook may appear uncertain, and there is still some value left in high grade corporate bonds, many investors and institutions continue to stay in cash or high yielding shares, awaiting the next opportunity.
