Freakish price insensitivity drives cruel bond markets

The sharp surge in bond yields last week cruelly underlined what a dangerous place bond markets have become.

For many investors gains since the start of the year were wiped out in a trice, indicating that the balance of risk and reward in this neck of the financial woods is hopelessly out of kilter. Yet some continue to buy eurozone bonds on negative nominal yields or, at longer maturities, accept yields that offer an inadequate premium over cash. Venture in at your peril.

Part of the reason this is treacherous territory is that so many market participants are insensitive to price. It is hard to recall a time when so much money has been driven by considerations other than price or value. The most obvious case in point concerns the bond-buying programmes of the European Central Bank and the Bank of Japan, which are motivated by broad economic considerations that make pricing irrelevant.

The ECB is seemingly unbothered about the prospect of incurring losses on the purchase of bonds at negative nominal yields - a freakish situation that has not yet arisen in supposedly deflation-prone Japan. It will be interesting to see whether financially conservative northern Europeans now start to worry about the damage that rising bond market yields inflict on the ECB's balance sheet.

Yet price insensitivity is also pervasive in the private sector. The fashion for liability matching pushes pension funds into buying bonds that are outrageously overvalued by historic yardsticks. The practice of "de-risking" into what are perversely called safe assets means, in practice, re-risking into wildly overpriced fixed interest paper.

Price insensitivity is equally pervasive in the equity market. The failure of active managers to justify their fees has swollen passive managers' pool of funds. Yet for all their advantages, most notably low fees, indexed and exchange traded funds are no panacea, as the bubble of the late 1990s demonstrated. The high-tech sector became such an important chunk of the overall market that passive investors and closet indexers became excessively exposed to the most vulnerable stocks in the market. The locus classicus was Vodafone, the telecoms group, after its takeover of Mannesmann, the German phone company, in 1999, which led to artificial weighting shortages. Fund managers piled into a stock that lost 75 per cent of its value in short order. In practice, price insensitivity turned out to be a recipe for buying high and selling low.

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With less of the market driven by price-sensitive investors, a diminished free float will inevitably be more volatile. That may partly explain last week's unexpectedly sharp gyrations. Once in a while money driven by fundamentals will try to reintroduce a germ of reality.

What can be done to bring back greater price sensitivity? Clearly central banks' quantitative easing will end in due course, causing bond yields to revert to something less abnormal. A market free of central bank intervention should also help active managers and stock pickers, for whom the Pavlovian risk-on, risk-off environment has been a nightmare. Whether they will take full advantage of the sunlit uplands, though, is moot.

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