Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

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.

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