As governments around the West print money like there’s no tomorrow, a few people are asking: is the bond market about to crash?
Tim Price of wealth managers Price Value Partners thinks it could blow at any moment.
Here’s his reasoning.
- What is worrying about the bond market?
- What is a bond?
- The problem with fixed interest right now
- The global bond market
- What should the investor do?
“I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.” – President Bill Clinton’s political adviser, James Carville.
Not that James Carville was wrong, but forty years of declining interest rates and almost limitless money-printing by the world’s central banks have largely pacified the so-called ‘bond vigilantes’ – those rogue investors who used to enforce discipline upon the government treasuries of the world by threatening not to buy their debt (i.e. their bonds) whenever their fiscal behaviour became outrageously lax.
First, a quick primer about bonds.
- A bond is simply an I.O.U.
- Governments issue them, and corporations issue them.
- A bond is nothing more than a series of cash flows.
- The UK Government, for example, has issued a 10 year bond (or ‘Gilt’, short for Gilt-edged security) which offers an annual income of a mighty 0.25%. Investors pay the Government 100% of however much they want to invest upfront; the Government is then obligated to pay those bond investors 0.25% every year until the tenth year, whereupon the Government also gives them their original investment back.
Why do governments issue bonds ?
- Invariably, because they don’t raise enough by way of tax to pay for their promised spending.
- The balance has to be borrowed, which is where the international bond market comes in.
Now, a quick bit of basic mathematics.
- Bond interest payments (also called coupons) are typically fixed.
- The return of the investor’s capital when the bond matures is also a fixed amount.
- What this means is that the price of bonds is acutely vulnerable to changes in either interest rates, or inflation.
- This makes intuitive sense. An instrument paying 0.25% annually is quite attractive when base rates are basically zero. But when base rates – or inflation – rise to, say, 5%, those bonds look pretty unappealing, so their prices fall to compensate investors for taking the extra inflation or interest rate risk.
And here’s the rub…
- There is an iron law in finance which dictates that if interest rates go up, bond prices go down.
- You can also say the same thing about inflation – inflation is deadly for owners of fixed income investments (i.e. bonds).
The global bond market is currently worth well over $70 trillion.
The chances are you have some exposure to that $70+ trillion of debt.
If you don’t, your pension fund probably does.
Now ask yourself a question. After an explicit policy of suppressing bond yields, and now that global interest rates are down to their lowest levels for 5,000 years, do we think bonds are outrageously expensive, or merely hilariously mispriced?
A follow-on question: given that the size of the world’s bond markets dwarfs that of the world’s stock markets, what do we think happens to stock prices if and when $70+ trillion worth of bond investors decide to head for the exits at once? We are in the process of finding out.
The world’s governments and central banks, in short, have painted themselves into a corner.
Since base rates are now basically around zero, they can’t realistically be cut any further. But because of the size of the bond market, and because prevailing interest rate yields in the bond market influence mortgage rates, and therefore property prices, central banks can’t realistically raise interest rates much, either.
This will prove a problem when the average investor starts to fret about rising inflationary pressure – which is essentially now baked in to the bond market, courtesy of all those years of money-printing.
Having slashed monetary policy rates to zero more or less across the board, central banks – through quantitative easing (QE) – have driven bond yields to more or less zero as well.
Indeed, over a third of sovereign bonds today now carry negative yields.
That’s despite the fact that there has never before been so much debt in the system.
It’s extraordinary. All things equal, the more of something there is, the less the marginal demand for it there should be, and its price should fall to reflect that.
But in the government bond market over the last two decades, the greater the supply – to all-time records, no less – the higher the price has gone, to the extent that roughly $13 trillion worth of government debt now no longer even offers a yield above zero.
the bond market is now uninvestible
Time to call a spade a spade. The bond market is now uninvestible.
The likelihood of meaningful further capital gains is limited.
The likelihood of catastrophic capital losses is high.
The only reason this absurd situation exists is that the cult of indexation ensures a ready market for capital tracking bond indices – which, as already discussed, represent a huge market by comparison to the world of stocks.
Another reason it exists is because the financial regulator effectively forces pension funds to own government bonds because they are deemed.. ahem.. riskless assets. The regulator can expect lawsuits.
What is the informed investor to do ? There are no panaceas.
What we do as an investment practice is avoid bonds like the plague.
- We see far greater opportunity in the stock markets, admittedly via defensively valued companies that themselves have little or no debt on their corporate balance sheet. We see opportunity in assets that are uncorrelated to the stock and bond markets.
- And we see compelling opportunities in the commodities sector, given the inflation popping up everywhere, and within real asset companies generating high cash flows but with little or no attendant debt. We love gold and silver.
The months and years to come will, I suspect, become a watershed period for investors in bonds. Owning bonds will prove to be a religious experience. But not in a good way.
This is why gentlemen should NOT prefer bonds.
Tim Price is co-manager of the VT Price Value Portfolio and author of ‘Investing through the Looking Glass: a rational guide to irrational financial markets’.
This is not financial or investment advice. Remember to do your own research and speak to a professional advisor before parting with any money.