Market bubbles occur when assets are extremely overvalued. Government bonds have arguably entered that inflated territory, as U.S. Treasury bills due in less than 90 days have been priced so high that there is no gain to be had in holding them. U.S. long bonds are also moving into that lofty space. And while Canada bonds still produce a return, it is unknown how long that will continue.

A conventional equities bubble occurs when a mass of inves-tors agree that the upside of an asset class is limitless — or, at least, far enough in the future that fortunes can still be made. An equities bubble is built on optimism without limit.

A bond bubble is different. One happens when a mass of investors agree that times are so bad that security is worth any price, even at prices so high that there is no rationale for making the investment. In a bond bubble, the upside is capped at the bond’s term and redemption price. A bond bubble is built on fear without limit.

By that definition, government bonds are in a bubble. A 90-day U.S. T-bill is currently paying a couple of basis points, which is almost nothing. Go out 30 years and you can get 3.6% on a U.S. T-bond. In Canada, short-term T-bills pay 1.9% and 30-year bonds pay 3.97%. Depending on the term involved, the yields are at or near historical lows.

“We are in a period of excess valuation,” says Michael McHugh, vice president of fixed-income and bond portfolio manager with Dynamic Mutual Funds Ltd. in Toronto.

On a relative overvaluation basis, money should be moving either to stocks, which are selling at deep discounts and have rich dividend yields to boot, or to corporate bonds, which offer rich rewards for taking on credit risk.

Yet, fear of loss is driving down prices of corporate debt, especially bank-issued debt. In the U.S., a JPMorgan Chase & Co. 4.75% bond due March 1, 2015, has recently been priced to yield 6.35% to maturity; the issue is senior debt with an AA- rating from Standard & Poor’s Corp. A Wells Fargo & Co. 5.58% bond due Dec. 11, 2017, which S&P has given a slightly higher rating of AA, has recently been priced to yield 6.21% to maturity. Both of these banks are in the “too big to fail” category, yet each is paying about double the rate for T-bonds of similar terms.

This implies that at some point, overpriced T-bonds will drop, says Mario de Rose, fixed-income strategist with Edward Jones in St. Louis. Mo.: “The long bonds will produce losses for those who bought them at recent highs.”

Canadian bank bonds don’t have such dramatic yield boosts. After all, no Canadian bank has failed in the current crisis. Yet, a Bank of Nova Scotia 6% issue due Oct. 30, 2013, with an A rating from S&P has recently been priced to yield 6.2% to maturity. Scotiabank common stock has recently yielded 5.9%. In this market, in which security trumps yield, the bond, which has a far higher level of security than the stock, pays more.

“If you parse the yield on government [bonds] back to what is driving the market, the yields make sense,” says Edward Jong, senior vice president with MAK Allen & Day Capital Partners Inc. and portfolio manager of frontierAlt Opportunistic Bond Fund in Toronto. “Do you really want to take on corporate bonds that have some equity risk in this market?”

The bond market has split into two separate markets: government debt that is being bought regardless of price, and corporate debt that is being sold regardless of yield.

This implies widening spreads; that is, government bonds rising in price, which is still possible for issues due in two or more years that have yields of a couple of percentage points or more, and corporate bonds falling in price.

This process of risk rejection also enables a perverse process to get underway in which government bonds priced just a few basis points from value at maturity are eagerly being bought by investors who seek to profit from deflation.

In deflation, the consumer price index falls, which raises the buying power of money. A $1,000 interest bill from a lender will really be $1,010 if the CPI falls by 1% a year as debtors rush to pay off their bills and businesses lower their prices to raise cash flow. This then leads to more deflation, more price-cutting and still more deflation. Government bonds with guaranteed value become ever more precious as the deflation-driven price levels decline.

@page_break@In this process, investors trade equity assets or inventory or variable cash flow for certainty, driving down real assets such as commodities and real estate, and pumping up bond prices. Known as the Debt-Deflation Model, this process was described by monetary economist Irving Fisher in 1933.

Fisher’s theory makes sense on its own merits, but in his own lifetime, his pronouncements on economic policy got short shrift. A few days before the market crash of Oct. 29, 1929, he told the financial press that “stocks had reached what looks like a permanently high plateau.” Soon after that, he told a meeting of bankers that securities prices were not inflated.

For his wretchedly bad market call, Fisher was sent to the gulags of economic theory by Keynesians who wanted to do fiscal resuscitation by pumping up government spending. However, Fisher’s debt-deflation theory has made a comeback. If Fisher is right, we shall be in deeper trouble. The debt-deflation spiral could be hard to stop.

The U.S. Federal Reserve Board’s funds target rate is now at 1%, down from 2.5% a year ago. The Fed appears to be running out of conventional ways to prod the economy. As the nominal rate sinks below 1%, the market will treat it as if it were zero.

Fisher’s model implies that the bond bubble has just gotten going. If prices drop by 2% a year, short bonds with essentially zero yields should appreciate in purchasing power by an annualized rate of 2%. The performance of long bonds with many interest payments to be boosted by deflation will be even stronger. A 30-year strip bond with a duration of 30 years will rise by 30% for every 1% decline in the rate of interest.

Says McHugh: “There is a prospect for rising long bond prices in this environment of sharp and sudden slowdowns in the global economy.”

There will be a change of heart in the bond market when confidence returns to equities. Then, there could be a rush to pick up high-grade corporate bonds and best-of-breed equities. Until then, there is not much that beats a government bond, even if it has a nominal yield of just about nothing. IE