The Age of Bonds Is Over
Bonds are now a lose-lose-lose proposition. And yet, almost all investors hold them, directly or indirectly. They’re the building block of portfolios and a key part of asset allocation.
Since the ‘80s, the bull market in bonds has been downright awesome. As interest rates fell, not only did investors benefit from high yields and falling inflation, but they also generated good capital gains.
This triple boost to bond market returns is what has made us so complacent about holding them, and what made bonds so popular too. But it is over. All three tailwinds are turning into headwinds.
In the future, bond yields will be below inflation, defaults will destroy invested capital, and bond prices will plunge, causing capital losses for anyone who joins the panic and sells out.
This means that, at some point, we’re going to see a panic of some sort in the bond market. And when bond markets panic, it’s far more destructive than a stock market rout. Because bond defaults are bankruptcies of companies, not just a loss of savings for investors. We’re talking unemployment, a drop in GDP, and serious economic disruption. Probably even a major financial crisis, depending on whose and how many bonds default.
Of course, I’m generalising about bonds broadly here. The bond market, like the stock market, is not a generic blob. It is full of companies offering good returns and bad returns, high risks and low risks, exposures to different industries and different places.
But, in this age of diversification and asset allocation, discussing what’s going wrong with the broader bond market is important.
It’s also obvious what’s wrong with bonds when it comes to yields, at least. The return that investors get if they hold the bond to maturity when the loan is repaid is simply too low.
The yield on an Australian government bond with one year to maturity is 0.008%, while inflation is 3.8%…
Why would you invest in an asset that is going to lose you money? Back to that in a moment. Because Australia is far from the extreme example.
Jim Reid of Deutsche Bank has pointed out that 85% of US high-yield bonds yield less than inflation. Read that again, with emphasis added: 85% of US high-yield bonds yield less than inflation.
This is absurd.
That number has never been above 10% and only rarely above 0%. It is reasonable, after all, to expect that a risky investment like a high-yield bond would pay you more than the inflation rate…
It’s the same over in the eurozone, with yields on plenty of junk debt turning negative for the first time ever. Reuters reports:
‘Yields on euro area junk-rated bonds have fallen below the bloc’s inflation rate for the first time, a further sign of the scarcity of assets offering investors any real returns.’
What’s going on here is that investors are seeking the higher yields of riskier bonds, but the very act of investing in junk debt bids up its price, which in turn lowers the returns on offer. So, as investors move along the risk curve in the hunt for returns, they reduce those returns too.
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But have they forgotten about the big risk? Back to that in a moment.
Bloomberg explained the vague justification behind buying the poor yields:
‘While [the low yields] means investors lose cash if holding the debt to maturity in the event inflation persists, traders can make money should it keep rallying. That’s been the case for euro-zone junk bonds this year as corporate earnings rebound.’
In other words, bond traders are speculating on continued capital gains and ignoring the risk of default and the yield on the bond.
This is a straight-up game of Old Maid, where someone gets left holding the bag, or in this case, the bond.
This folly is even more obvious for bonds than other financial assets because bonds have a maturity, meaning they expire, unlike stocks or Bitcoin [BTC], which can at least theoretically go up forever.
This means bond traders have turned the bond market into a time bomb by bidding up prices to unsustainable yields. At some point they must crash.
Alongside bidding up bond prices, inflation is, of course, what’s turned real bond yields so negative. Inflation in the US, eurozone, and Australia has surged recently.
Bloomberg’s expert explains that bond investors are in effect betting inflation will fall, returning their yields to more respectable levels:
‘“Most market participants think it [inflation] will drop back to the old levels once the Covid stimulus is withdrawn,” said Konstantin Leidman, portfolio manager at Wellington Management International Ltd, which manages more than $1 billion in European high-yield assets. “Should it not be the case, this will be a problem for many financial markets.”’
So, if inflation persists, this will expose high-yield and junk bonds to be as bad an investment as they look under current inflation rates. And, for the situation to correct — for bond yields to adjust for inflation and provide investors with decent yields — bond prices would have to fall. Dramatically.
But here’s the thing — if inflation will come down as COVID stimulus is withdrawn, what else will happen?
These high-yield and junk bonds have low ratings for a reason. And it’s because of the risk of default.
So, what happens when governments and central banks withdraw their support for companies post-COVID and the defaults they have thus far prevented start to play out?
Then the yield on bonds won’t matter because of the risk you’ll lose your initial investment in a default.
Thus, even if inflation falls, the bond market is a time bomb.
The third possibility is a steady and calm withdrawal of bond prices to provide more reasonable yields adjusted for inflation and default risks.
The third possibility is also a time bomb. An adjustment to more reasonable bond yields implies falling bond prices and thereby capital losses for bond holders. That’s because bond prices have to fall for their yields to rise, just as share prices have to fall for dividend yields to rise.
But this capital loss reverses the traders’ incentive for holding bonds in the short term as their prices are bid up. And that could mean traders make a dramatic attempt to get out of a burning theatre at the slightest hint of smoke.
Bond prices could overcorrect to the downside as nobody wants to be left holding a bond that may default, and which pays a yield that doesn’t even compensate for inflation, and which has a falling price too.
If the main reason to invest in something is that ‘it is going up’ then when it stops going up…
Investors, who are slower to leave a position than traders, would be left shouldering such capital losses on bonds, unless they are willing to hold to maturity of the bond. In which case, they get the current very low rate of return.
As I see it, whether it’s default, inflation, or capital losses, bonds are now a lose-lose-lose proposition for investors.
This may seem bad, but don’t worry, the government is here to help…which means make things worse.
Don’t forget, part of what’s going on here is financial repression. Governments are trying to reduce the weight of their debt by making that debt worth less over time. Inflation makes money worth less over time and thereby makes debts easier to repay in the future too.
But this only works if interest rates are pinned down, preferably below inflation. If interest rates rise with inflation, then the benefits of inflating away the weight of debt are cancelled out as the interest bill rises.
And so we get the task given to central bankers: keep inflation high and bond yields low, without causing panic in the bond market.
Thus, our Reserve Bank of Australia is busy pinning down the three-year bond yield to 0.1%, despite inflation running at 38 times this level. That, my friends, is financial repression.
Central bankers may be perfectly aware that inflation is dispossessing bondholders. And they might privately be aware that the inflation they’re causing is not so transitory after all. Their true policy aim of rescuing governments from impossible debt loads financial repression requires this deception.
So, what can you do about all this?
Dylan Grice of Calderwood Capital, our keynote speaker at a conference in Sydney many years ago, has a unique solution to all this.
In an interview with Wealthion, he explained how his fund tries to find investment opportunities not directly related to financial market action. He sees the possibilities in mainstream markets as exhausted and repressed.
At least, that’s what Dylan talks about in part two of the interview. Part one is about what Dylan makes of the overall situation in financial markets. I can recommend both, even if only for the entertainment value of a thick Scottish accent bamboozling an American interviewer.
Until next time,
Editor, The Daily Reckoning Australia Weekend
PS: Our publication Money Morning is a fantastic place to start on your investment journey. We talk about the big trends driving the most innovative stocks on the ASX. Learn all about it here