Say Goodbye to the Yield of the Century

Interest Rate Crash

Say goodbye to the yield of the century. That’s what some investors must be thinking — sadly I’m sure — after the last outstanding US Treasury with a 10% coupon expires this week.

What’s the story exactly? In August 1985, thirty years ago this week, the US Treasury issued $7.15 billion in bonds. They paid 10.625% in annual interest payments.

At the time, Ronald Reagan was President and a 30 year mortgage in the US came with an interest rate of around 12.4% that year, according to Reuters.

Here’s why it matters today. It’s quite possible we won’t see yields like that again in our lifetimes. In fact, yields were only pushed that high three times in the last century.

At the very least, Bond manager Bill Irving says there is only a 1% chance of yields going over 10% again in the next 10 years.  Reuters cited him as saying:

‘”Over the past 100 years, we’ve only had three episodes of 10 percent-plus inflation: World War One, World War Two and the inflation mistake of the 1970s,” he said. “Many of the market-makers on Wall Street were not working the last time rates were rising.“‘

Investors are despairing on where to find something that actually yields an income. But consider the implications for the US government. It can now issue bonds paying under 3%. It can rollover its debt at lower cost. This reduces its interest bill as it pays off the bonds issued years ago at higher rates.

The market is pricing in low inflation to come for a long time yet — we’re talking decades. The Financial Times reported this week that governments and companies are issuing record amounts of long-term debt.

The figure is already at $253 billion so far this year. That’s already well over last year’s $188 billion, according to Dealogic. The FT said: ‘Locking in low rates for decades enables governments and companies to push back debt refinancing needs and keep funding costs low, according to the Ministry of Finance in Canada, which issued the country’s first 50-year bond last year.’

You can see that trend happening here…

Source: Financial Times


The current low bond yields of course affect the pricing of other asset classes, stocks and property being the most obvious.

First State Super’s Chief Investment Officer Richard Brandweiner mentioned as much in relation to a recent property deal it was involved in. Low interest rates and low inflation put valuations in a different context than 10 years ago.

First State Super made the news this week after The Australian Financial Review revealed it had set aside $500 million to lend in the commercial property sector. Most of that is earmarked for overseas apparently.

However, according to the AFR, it just helped Fund Manager Forza Capital finance a deal to buy a $20 million Brisbane office tower. What was notable was that the major banks had declined to finance the deal.

The reason I find it interesting is while the mainstream headlines focus on the major banks cracking down on property lending, there are developments that show others will step in and take the business off them.

Let’s not forget the non-bank lenders. Take Pepper Group [ASX:PEP]. Pepper is a non-bank lender (mostly mortgages and auto finance) and loan servicer that listed on the ASX recently. It’s based in Australia but with international operations.

Pepper’s ‘organic’ growth strategy is to continue to go after the ‘non-conforming’ market. These are borrows that are disqualified from access to credit in the standard way.

But here’s the important point for today from Pepper’s prospectus:

In this environment of increasing regulatory oversight, non-bank lenders are emerging as credible competitors to traditional bank and other prime lenders…

‘Non-bank lenders are not required to hold the same level of equity capital against their loan books, principally reflecting the fact that they are not funded via retail customer deposits.

Get that? Mortgage-backed securities are making a comeback! According to that same document, mortgage backed securities rose 18% in 2014 from the previous year. For the non-bank sector specifically, the growth was higher at 30% or $6.7 billion in total. Expect this trend to continue.

And if you think Australian real estate is nothing but a ‘bubble’ — merely a pinprick away from collapsing — I have some recent figures for you:

Last week CoreLogic RP Data said Australian housing is now worth more than $6 trillion. That’s a $2 trillion rise in value since 2009.

But for our purposes today, note the level of debt held against that real estate. Excluding vacant land, the level of debt is only $1.3 trillion.

Of course, $1.3 trillion is a lot of money. But so is $6 trillion. So with a little maths, the level of debt against Australia’s real estate values is just 22% of the market.

That’s a low figure. By comparison, CoreLogic says the figure is 40% in the US.

If you ask us over at Cycles, Trends and Forecasts, what’s likely to happen from here is this: the level of housing debt in Australia will go up. We’re not in bubble territory yet. Find out how to take advantage of it here.


Callum Newman,
For The Daily Reckoning

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Callum Newman

Callum Newman

Callum Newman is the editor of The Daily Reckoning and Associate Editor of Cycles, Trends and Forecasts. He also hosts The Daily Reckoning Podcast. Originally graduating with a degree in Communications, Callum decided financial markets were far more fascinating than anything Marshall McLuhan (the ‘medium is the message’) ever came up with. Today Callum spends his day reading and researching why currencies, commodities and stocks move like they do. So far he’s discovered it’s often in a way you least expect. To have Callum’s thoughts and insights on the current state of the currency, commodities and stock markets delivered straight to your inbox, take out a free subscription to The Daily Reckoning here.

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