Where Have All the Bond Vigilantes Gone?

Investors see "modest growth and continued declining inflation"

As nations around the globe blow holes in their budgets and flood markets with unprecedented amounts of debt, bond investors have remained surprisingly willing to accept low yields on government bonds. The bond vigilantes who normally punish profligate countries by demanding high returns have been missing in action.

While a few troubled nations like Greece are paying higher rates, sovereign bond yields recently averaged 2.39%, about the same as a year ago and below the average of 3.08% in 2008, when the credit crisis led investors to the safety of government bonds, according to Bank of America Merrill Lynch (BAC) index data. The cost to borrow is holding steady even though the amount of bonds in the index has grown to $17.4 trillion, from $13.4 trillion at the start of 2008.

That big debt expansion helped revive the global economy—but hasn't yet generated inflation, which erodes the value of fixed-income securities. Consumer prices (excluding food and energy costs) rose only 1.5% in February from the previous year in the 30 countries that form the Organization for Economic Cooperation & Development, the smallest gain on record.

"Part of what's frustrated bond vigilantes has been that economic data has ratified the notion of modest growth and continued declining inflation," says Wan-Chong Kung, a money manager at FAF Advisors in Minneapolis, the asset-management arm of U.S. Bancorp (USB). (The term "bond vigilantes" was coined by economist Edward Yardeni in 1984 to describe investors who sell bonds in response to inflationary monetary or fiscal policies.)

The low rates have taken a big bite out of governments' annual interest payments. In fiscal 2009 ended Sept. 30, the U.S. paid $383.4 billion to service its debt, down from $451.2 billion in the previous year, says the Treasury Dept. Even with rates low, demand for U.S. debt remains robust: On average, the Treasury received $3.21 in bids for each dollar sold at 10-year offerings this year, compared with $2.63 in 2009 and $2.41 from 2004 through 2008, according to Bloomberg data.

A lot of that demand is coming from financial institutions, which are profiting from the difference between the near-zero rates they have to pay to raise cash in the money markets and the higher yields of government bonds. In the U.S., banks owned $1.48 trillion of government securities as of Apr. 7, up from $1.09 trillion two years earlier, Fed data show. Today's easy credit conditions likely will end when investors see signs of inflation. "There's a philosophical battle between those who feel the deflationary forces are very powerful—and I'm in this camp—vs. those who say, 'hey, you're printing tons of money, you've got to have inflation,'" says Barr Segal, a managing director at Los Angeles-based TCW Group. "And they're right, too. The big question is timing."

The bottom line: The combination of moderate economic growth and low inflation means bond buyers will accept low yields on their investments.

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