UK Indexed Bond Bubble

John Plender has an interesting article in the FT (Risk aversion and panic buying, Financial Times, January 23, 2006) on the bubble in the UK inflation indexed bonds. Yields on the 50 year indexed bond have fallen to the extraordinarily low level of 0.38%. Plender argues that unlike other asset classes where bubbles arise from irrational exuberance, here it arises from panic or high risk aversion.

Compared to typical estimates of the historical average real long term interest rate of around 3%, the yield of 0.38% does appear ridiculously low. However, the situation is not so bad when we compare 0.38% with the historical average real short term interest rate of around 1%.

Morgan Stanley economists Richard Berner and David Miles discuss the issue of low long term yields in the US. They refer to the interesting FEDS paper by Don Kim and Jonathan Wright of the US Federal Reserve which decomposes the long horizon forward rate into four components. Recasting that analysis in terms of the real interest rate of a long term nominal bond we get three components:

• the expected short term real interest rate
• the real term structure premium
• the inflation risk premium.

The last of these is not present in an indexed bond and therefore the yield on an inflation indexed bond is likely to be lower than the real yield on a nominal bond. The interesting part is the real term structure premium. Kim and Wright show that this premium has collapsed from 2% in 1990 to 0.5% in 2005. From a theoretical point of view this premium can fall further and can in fact be negative. Only the liquidity preference theory of the term structure predicts a positive term structure premium. The expectations theory predicts a zero premium and the preferred habitat theory is agnostic about the sign of this premium.

Plender believes that indexed bond yields are depressed because pension funds are buying these assets for regulatory reasons and that the bubble could be pricked if either they turn to other assets or if the government could signal an intention to issue more long term indexed bonds. In the terminology of the preferred habitat theory, this merely states the truism that the term structure premium will change dramatically if some lenders or borrowers change their preferred habitat.

In the days when indexed bonds yielded say 3%, this yield would have decomposed into a expected short term real interest rate of say 1% and a term structure risk premium of say 2%. An yield of 0.38% would imply a term structure premium of -0.62% assuming that the short term real interest rate is unchanged. It is difficult to understand why a fall in the absolute value of the risk premium from 2% to 0.62% could be interpreted as a rise in risk aversion let alone as panic.

I share the view that there is a global asset market bubble and am quite sympathetic to the view that there is a bubble in UK indexed bonds as well. But I believe that Plender’s analysis is over simplified.

Posted at 12:44 pm IST on Tue, 24 Jan 2006         permanent link

Categories: bond markets, bubbles

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