Bill Gross

Are bonds, especially Treasurys, in a bubble, driven up by by a mob of wild-eyed coupon clippers, fighting to get 0.87% on a five-year traditional Treasury?

I ran across these comments from Bill Gross, co-founder of Pacific Investment Management who is also known as ‘The Bond King,’ while reading a week-old Barron’s. (I get behind, sorry). This is from the annual Barron’s Roundtable, part 3:

The Fed is buying 80% of the Treasury market today. It is remarkable to think that when the Treasury issues debt in the trillion-dollar-plus category, the Fed ends up buying most of it. The Treasury sells it to the banks and primary dealers, who sell it back to the Fed at a higher bid. This is a very different financial system from the free-market capitalism we’ve come to know. And it will continue until inflation exceeds the upper end of the central bank’s target of 2.5% or, by some miracle, we get real economic growth. …

With yields so minimal, an investor is obliged to ask whether investing is worth the risk, given the possibility that the central bank misjudges the situation. … The public doesn’t realize that when yields come down, prices go up, and when yields go up, prices go down. ….

Let me be clear. Bonds are artificially priced, but aside from long-term bonds, there don’t appear to be the elements necessary to pop the bubble. That’s because central banks are buying the majority of bonds, and the cash flow from the existing stock of bonds, when reinvested, as most is, is more than the supply of bonds.

My question is: If one buyer – a buyer than can magically create dollars – is buying 80% of U.S. Treasurys, can you call that a ‘bubble,’ or is it outright market manipulation? Are there great hordes of Americans buying Treasurys? Obviously not, if the Federal Reserve is buying up 80% of the new supply.

TIPS buyers, though, are bidding against both the Federal Reserve and a large contingent of investors who truly fear future inflation. And that is pushing TIPS up. Here is a 2-year chart of the TIP ETF versus Vanguard’s Total Bond Market ETF:

These two funds have similar durations, but the Total Bond Market has greatly lagged the returns of the TIP ETF over the last two years. By the way, the Federal Reserve began its market manipulation in mid 2011, and at that point the TIP ETF sharply changed course.

It is not a coincidence. It is market manipulation. Can that continue forever? No.

Are bonds overpriced? Yes. It there a bond bubble? My answer is no. Not at least in the total bond market.