It is not the yield that is as important as the direction of that yield, up only. Bond math is a vector not a scaler.
quoting
naddr1qq…kckdAs I entered my current era of investing in 2019, within both my client managed and Vanguard elements of my investments, I was directed towards holding bonds, “because they’re safe” and can provide some stability to a balance portfolio. I really had no idea what they consisted of, I really should have done by own research, but still, I’m sure something similar can be said by many investors. On the face of it, they provided a steady return, and in market down turns, I was told they might increase in value to help balance out the value of my equities that may go down in a downturn. It sounded oh so simple, but looking back, that was all logic from a very different time, following the GFC, interest rates were historically low, meaning the contribution of the “bond portion” of a portfolio was near zero, while robbing you of the upside of equities. And then, there were the client information sheets, or my bloody financial advisor (who technically could not provide advice), didn’t mention a small issue known as interest rate risk, that when we were hugging the zero bound had to be something staring any purchaser in the face. But alas, we are already getting far ahead of ourselves before we’ve even entered the strange and complicated world of “bond math” (that only an economist could understand), so let’s attempt, as my father would say, to “work it out with a pencil”.
What the hell is a bond anyway?
I’m going to try and keep things simple here, because I’m not an economist, but then, by not being an economist, I won’t attempt to bamboozle you with technical terms. In its simplest for, a bond is like a loan, where someone borrows money, sort of like an interest only loan, where depending how much you trust the person you are lending the money to, but also how competent they are, you will charge them more or less to make it worth you not having that money. Compared to a normal, interesting and principle type loan, bonds are different, where you pay the rate of interest through the life of the loan, and then at the end of the bond term, you then pay the whole amount back, at par. However, unlike a traditional loan, bonds can be traded, so if someone owns you money with interest (known as a coupon), if you actually want your money back, you can sell it to someone else and they can then have the interest. Complications begin to be introduced into this situation when the economic environment or indeed to competence of the person you have lent to changes over time. Imagine lending £100 to a lumberjack, with a 5% couple, they were competent and there were trees to cut down, they were low risk. However, what would happen if, say the lumberjack put on a lot of weight, the market for lumber had a downturn or many more lumberjacks entered the market. If any of these situations occurred, the next loan the lumberjack wanted to take out would probably have a higher interest rate, because they had become a higher risk. But, if the original bond/loan is still outstanding, how can we value this bond and change in scenario, given it is not returning as much as the market rate the value has potentially reduced to make it as appealing as the new higher return bonds available in the market. Let’s run the numbers.
Loan 1: £100 with a 5% coupon = £5 per year
Loan 2: £100 with an 8% coupon = £8 per year
To make them equivalent, Loan 1: £62.50 with a £5 coupon, meaning if you buy £100 of Loan 1, you would receive £8 per year in the coupon.
Using the medium of beer to communicate this idea.
>The volume/value of the Stella would have to reduce to 330ml, with the same alcohol content to have the same “kick” as the Duval. In this example, the volume of the beer is the equivalent of the fiat value a bond can be sold for, with the alcohol content representing the coupon. In a similar way, if you had bought loan 2, and the lumberjack returned to prior levels of loan worthiness, reducing the rate to 5%, the volume of Duvel would increase to 528ml or the value of the loan would be £160, a night 60% return.
So, returning to the previous section with the model, 60/40 portfolio, within a context of near zero interest rates, if there are any increases in interest rates in the bond market, the value of the bonds themselves will reduce dramatically, so seriously harming investors’ portfolios. While this was never really spoken about, although I must admit I was not really listening, when the US began to attempt to raise interest rates in 2018, this caused problems in the bond markets, which may have been people holding bonds returning very low interest bearing bonds wanting to get rid of them as quickly as possible, before the value fell. The problem was then as they attempted to get rid of these bonds into the bond market, this itself caused the value of these bonds to fall further which was seen in the bond markets as “yields rising” and make values fall further, as people wanted to own the newer issued, higher yielding bonds. With bond yields increasing rapidly and bond values falling quickly, I believe this is what became known as the “Repo crisis” of 2019, which in a way was only resolved once there was a return to zero interest rate policy after the covid crisis in March the following year.
The end of a low-interest rate environment
Since these dramatic events, the general fragility of the global financial market has since been demonstrated on a number of occasions, alongside awareness of some of the unintended consequences of the emergency policies enacted as a result of the Covid crisis. While not wanting to rerun all that went before, to put it mildly, the crisis allowed some biblical levels of money printing to allow people and companies to continue operating even if products and services were not actually being traded. The knock-on effect of this, a couple of years later (2021-2022), was that as demand (and savings), combined with supply chain issues along with all sorted of spectres plucked out of the ether were identified as the cause of inflation, but much less attention was given to linking inflation to the dramatic increase in money supply. From an economic perspective, the solution to this was that due to the low interest rates, leading to increase levels of lending, had created excess demand and so inflation. The solution was to increase central bank interest rates, which would curb the level of lending, so slow inflation. The problem with this was similar, but to a much greater extent than 2019, as Fed interest rates when up from around zero to around 5% in the fastest rate hiking cycle in history, the value of bonds fell precipitously.
At a surface level, this helped bring down inflation, but for all those banks who had bought the bonds (at the request of the government), were now holding long term loans that were now trading for a fraction of their original value. This meant that if the bank needed liquidity for an emergency, they would have to market sell these bonds, leading to a huge loss, and then after this was circulated within a Silicon Valley WhatsApp group (or similar), there was a run on Silicon Valley Bank in 2023, as people attempt to withdraw their funds before the bank had to begin liquidating their bonds (and potentially go bust). Slightly earlier than this in the UK, in October 2022, when there was an ill-fated “mini budget”, the bond market moved rapidly, so companies (pension funds) that had leveraged low yielding bonds to increase returns, began to receive margin call as the changes in bond value were magnified by the leverage the bond market stopped functioning, as bonds were not getting bought. Both situations highlighted the risks that can occur from holding low yielding bonds, long term bonds, particularly when without warning there were changes, particularly after Jerome Powell had said prior that he wasn’t thinking about considering raising rates before he started marking rapid changes. With all 3 cases, the central bank had to “inject liquidity” to allow the markets to continue functioning, which effectively meant buying bonds to providing the previous holders with more liquid assets to trade.
While many predicted that such a rapid increase in central bank rates would cause a recession in the US, interestingly, at the same time as rates were being increased, the economy was also being simulated, due to the budget deficits continuing to inject money into the economy. As a result, even though consumer spending and investment may have been constrained due to higher interest rates, the money from the government meant, while there may have been a “technical recession”, the government managed to define it differently, so dodge this terrible outcome. As a result, the US economy has continued to function, even if hampered by ever increasing debts and interest payments, by being kept on life support by a constant stream of government debt and more recently, gargantuan spending of the AI hyper scalers. At this point, while rates have been reduced slightly, and Trump would like them reduced further, markets are continuing to function, for the time being.
But Saifedean suggested Inflation was not Simply a Scaler Metric
While this discussion is not specifically focused upon inflation, I tend to write about that extensively, so it can be left to one side, inflation is (with some caviats), an outcome of increased money supply, which resulted from increasing amounts of debt. The reference made by Saifedean in the Fiat Standard (p.53), itself references Michael Saylors (Strategy CEO), who stated that inflation could not be represented as a single number, because everyone purchases different items, so experiences inflation at different rates. It all I’ve bought was TVs for the past 30 years, I’ve experiences serious deflation, but if I’m a fat out of work lumberjack (this may be a useful reference point), with arthritis, the cost of my medical bills and medicine have been increasing dramatically over the same period. Within these two examples, the rate of in/deflation of these two markets has been affected by the rate of change of inflation over time, or more precisely, the ability of each of these markets to operate more efficiently overtime (more value of less cost). This introduction of time then introduces a direction in addition to the scale of the increase to inflation, allowing people to change their purchasing choices to maybe buy what may increase in value over time, and maybe put off buying a TV, until there is a cheaper better version. Unfortunately, due to the unplanned nature of many medical expenses, this is not always possible, but this is a discussion for another time, instead we can return this discussion to bonds.
Above, the idea of interest rate risk was introduced into the “safe” bond portion of the model 60-40 investment portfolio, where, irrespective of the coupon one collected on a bond, there was a risk that the value may reduce if interest rates increased. If the plan for the portfolio was to hold the bond until maturity, that was not an issue, but if for some unexpected reason, liquidity was needed, this would create problems. The establishment of this portfolio model has become so entrenched due to the amount of “empirical evidence” of the performance of this structure over time and through market downturns. However, taking a step back, if we consider the idea of interest rate risks when at the beginning of this 40 year window were historically high at close to 20%, since this time, the trend has been for ever lower interest rates, so ever higher bond values. During the GFC of 2008, when zero interest rate policies were introduced, this trend came to an end, but unfortunately, the model portfolio did not, so while bonds may buffer market down turns, there is no longer the constant bump in value, as interest rates reduce over time.
From this situation, as with inflation as a vector (which I’m not 100% sure I agree with, the direction only comes in when looking at operational efficiency improvement), interest rates, but specifically bond returns, need to be viewed not only as a figure. While the coupon may be sufficient to provide a steady income for a retiree, the risk that the value of the asset could dramatically reduce over time needs to be considered, why buy a long-term bond when I shorter term bond holds much less of this type of risk? Then, this is without considering the value of the dollar, pound, yen or euro you receive after the term of the bond, which is again inflation related, but ultimately, the fiat you receive at the end of this term will have been devalued as a result of inflation. From this position, while the return on a bond may be appealing, the long term value of what you’re receiving is going down, and there is a risk that the value of the bond, if you needed to sell it might also go down. From this position, if we stop viewing bonds as a yield generating device, but a trade, buy them when they’re cheap, sell them when they’re expensive, they begin to make more sense (or vice versa with a short position), particularly if we have an idea of where the market may be moving. In the 80’s, obviously in hindsight, this was obvious, the GFC was potentially more difficult to predict, but in terms of the ensuing zero interest rate period, it was logical that rates would have to increase one day, so you really didn’t want to own bonds during this period, unless you really had to (government mandates).
But what does this mean moving forward?
Although there has now been a number of years of relative stability (maybe 3), the above line “for the time being” is important. The Repo crisis, the guilt crisis and Silicon Valley Bank crash were the result of rapid changes in bond yields that created market and business disfunction. However, currently, the benchmark 10Y government bond is significantly higher that the levels they were during prior crises and the market is continuing to expect high rates to offset worsening conditions. Within the major markets, growth is not materialising, legislated expenses (defense, social security etc) are only ever increasing and the interest expense, simply to maintain the existing debt load steps up every time the yield increases on longer date bonds. From this position, one may say that at yield of over 5% of a British gilt represents a good investment, if you can live off this return, unfortunately, given the direction of travel of this figure, yield is likely to increase over time. The scaler figure looks good, but the direction suggests the value of the bond will fall, suggesting you should put off buying this bond until the yield is higher or buy something else. From an investor perspective, the answer to this situation is to not buy longer term bonds, instead focus on shorter term bonds, or alternatively look for high yield products, which to refer back to earlier, the AI hyper scalers may be able to offer you.
Now from this position of the individual, as is the preferential perspective of an Austrian economist, we have potentially established that unless we really have to, it is probably better not to purchase or hold government bonds, unless we can see a rate cut in the future. Apart from market disfunctions such as the GFC or Covid, where rates were dropped to help the system, traditionally rates would fall in an effort to spur growth, following a market slowdown, ideally following a period of growth, where rates had been raised to curtail excessive borrowing. The problem for global governments at the moment appears to be that irrespective of what they do with rates “at the short end”, the longer-term debt will continue to rise and traders continue to want higher returns. With the amount of debt the major governments hold, as stated above, the interest expense will continue to rise, which in turn makes it more difficult for the government to service their debt, leading to traders wanting even higher rates, rinse and repeat, and debt doom loop is closer than it appears.
To return back to the Lumberjack example, who originally took out a £100 loan at a 5% interest rate. Since this initial loan, the lumber sector as got more competitive, meaning the income from his business has reduced making it more difficult for him to make money and repay the loan. However, his mortgage still needs paying, his family have continued to ask to go on holiday and have their school fees paid, so to fill the gap between the Lumberjack’s income and his expenses he has taken on more loans, at a higher rate further pushing him into difficulties. Lucky for him, he has a friend who is a banker, who has offered him an even bigger, which will pay off both loans, but offered him a lower rate over a longer term (he’s remortgaged the house). While this solved the problem in the short term, the lumber industry as continued to experience difficulties, alongside the lumberjack’s arthritis getting worst, meaning even though the debt repayments were reduced, the income is still not able to cover them. The person the Lumberjack thought was a friend has now returned, willing to offer a shorter-term loan to cover the loan repayments. Whether the rate of this loan is high or low, the situation the Lumberjack is in cannot be escaped without some significant changes, whether declaring bankruptcy, cutting expenses dramatically or moving into a new more profitable business sector.
At this moment in time, the yield on government debt looks like it may have a good return, but it will likely increase. The doom loop then becomes a closer to a reality (the deficit spending nearly guarantees it), as the market starts to say they are unwilling to buy bonds at current yields, and an emergency intervention (to a bigger extend to the Treasury doubling long dated buy backs in August) has to take place. At which point, “liquidity” will have been injected in the form of a “Big Print”, which will in the short term allow the government lower yielding rates for their borrowing, but in the medium to long term, reduce the value of each currency unit without the natural debt buyers return to the market (as has been the case in Japan). Again, the idea of inflation is introduced, as well as the direction component, if the only option governments have is to manage their bond markets through increase debt issuance, the underlying value of the bonds unit of account will both reduce over time, at a potentially increasing rate (hyperinflation?). I’m not a macro analysis, and certainly not a bond math expert, but based on my understanding, while it can potentially be traded by people more informed than myself, should only be held with a clear understanding of these risks. The equity portion of the portfolio could remain, although this too is denominated in fiat currency, so has to increase in value more quickly than the rate of debasement. The bond portion of the portfolio, outside short dated, cash like assets ready to deploy, needs to be removed. In my view, an asset that cannot be printed to support the functioning needs to be held. Equities that are able to denominate profits in hard assets that also cannot be devalued can be held, but bonds, until we move back into a world where government debt is under control and the trajectory is lower rates, are un-investable. Until the Lumberjack has got his debt under control, told his family there is no holiday this year and improved the profitability of his business, he doesn’t have a bright economic future.
To return to where I started, if I was to be advised by a platform, or a financial advisor, that it was important to hold bonds, if nothing else, I think I’m now better informed to ask why?l