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Lundi 18 Juin 2012


By Stewart Cowley, Manager, Old Mutual Global Strategic Bond Fund.

Stewart Cowley
Stewart Cowley
If regulators think the Facebook IPO was a scandal, they should look at the German government bond market.

“I know a bubble when I see one,” said the world’s greatest bond manager, Bill Gross of PIMCO, when describing the Facebook initial public offering. We can now see that Bill had a point. At an initial valuation of nearly $105bn, each of Facebook’s 900m active users was valued at nearly $120 of annual advertising revenue. Put it another way, with revenues of $3.5bn it would take 30 years to pay off the original valuation of the company. Pretty steep you’d agree.

So with a hop, skip and jump of logic, ask the question: “Why would you buy something that is twice as absurdly valued as Facebook?” What bubble hasn’t the world seen that it would merrily continue buying something that is one day a guaranteed to make a loss? We speak of course of German government bonds, or bunds, or to coin a phrase, Facebunds.

To see how we get to this idea let’s look at bond maths. Duration is a measure of a bond’s price sensitivity to yield movements. The higher the duration, the greater the price movement of a bond for any given yield. German bunds with a maturity of 30 years currently have a duration of 20 which means that for any one point movement in the yield up or down you will lose or gain 20 points of capital. This is benign when yields are falling but painful if they rise, even a little bit.

Another way to look at duration is to think of it as the time it will take to get half your money back. So, if we equated this to our Facebook shares then they would have a ’duration’ of 15. In other words, long-dated German government bonds are more absurdly over-valued than the absurdly over-valued Facebook shares. Facebunds.

There are very good reasons why German bunds have reached this point (we have helped clients profit from this recently) as they have become the safehaven asset in a world that wants to hide its euros away from the Greek, Italian, Spanish and French banking systems. But there should be a limit to what should be paid for such safety, even by the most petrified of investors.

To benchmark the process let’s compare the situation with that other absurdly valued bond market, Japan. Facebunds now yield less than their Japanese equivalents in maturities under three years. There is some difference in the middle part of the yield curve but once you get to the 30 year area the madness takes over again. Overlay the US and UK markets and they now look like a positive bargain, thougheven there in absolute terms yields hover around 3%.

Unless you really think that the panic that is gripping Europe will spread along the yield curve sending yields to or through Japan (10 year maturity bunds would rise another 4.8% in capital value if they fully converged to Japan) then Facebunds have some – but rapidly dwindling – value. At the very long and very short ends of the yield curve the game is already over.

Who is to say that in the weird world that we now live in, that Facebunds won’t trade through Japan right along the yield curve. The capacity for human beings to panic appears to be boundless so it would be a brave person who would be an outright short of the German bond market right now, especially when we have an unstable political system in Greece and a silent run on the Greek banks which may be gathering momentum.

But to put a toe in the water, to recognize that something is wrong here, we have decided to express the idea that this process has gone too far by selling futures on long-dated German government bonds whilst simultaneously buying long-dated bonds in the US and UK. If German bunds underperform their US and UK equivalents the trade will create a positive return for the fund; if they continue to outperform then it will create a negative return.

Obviously, there are circumstances where Facebunds will continue their lonely descent to zero percent yields but in absolute and relative terms it’s becoming more and more difficult to see this as anything other than a finite process. If things were to get materially worse in Europe money would flood out of even Germany, sending the euro down and government bond yields up. At the same time many and any of the solutions being proposed for Europe (smearing out the credit rating of the stronger nations across the map of the euro for instance) should see bund yields rise even if because of a short-term sense of relief. For instance, should the political rhetoric of leftist parties in Greece soften or the election in Greece send the message that the Greek people want to stay in the euro, again, Facebunds will be the loser in absolute and relative terms.

A relative value trade as described above, matching German against UK and US bonds, is a lower risk way of doing what many have tried recently and failed to do; call the turn in the government bond markets. It’s our toe in the water because, like Bill, we know a bubble when we see one.

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