ANOTHER SITE: fixed income

The upside down, inside out negative yield financial world

As Keynes has said “The market can stay irrational longer than you can stay solvent.”

Fixed income investors are having a great laugh with strong bond performance this year as yields move further into negative territory in many countries and close to all time lows in the US. The individual facts are astounding. The German government issued 30-year bonds with negative rates. The Austrian 100 year bond is at a zero rate. 44% of the Barclays/Bloomberg Aggregate index outside the US is negative. The dollar amount of negative yielding bonds is now $15 trillion. The Eurozone investment grade bond index has a yield to maturity of .24 bps. Every basis point decline in yield places more debt into negative rate territory. You can now borrow for a negative rate mortgage in Denmark.

Try explaining negative rates to anyone and you are immediately placed in an odd world. There is no normal time value of money. Yes, there is time value except a lender will give you the use of their money today in exchange for less money tomorrow. A borrower can obtain money today with the promise to give the lender less money tomorrow. The lender says that he has no known use for his money and would rather give it to someone else in exchange for less money in the future.

The credit is willing to take a penalty for giving up the use of their capital as debt. They must be very afraid of future returns for equity. While there are other alternatives, creditors are willing to lock-in a sure loss over the uncertainty of something else. Note that holding paper money will lock-in a loss of zero. The risk of inflation applies to bonds and cash. Insurance companies with long liabilities are saying that they will take a penalty to closely match their long-term obligations and there is little fear of any future inflation. Creditors are driving up bond prices to create negative yields, a form of scarcity.

What is as surprising as creditors accepting these negative rates is the lack of new government bond issuance at these rates. For all the countries that have negative rates, it seems that they should be exploding their balance sheets for any capital improvement project that has a positive net present value. This should continue until rates are driven higher.

You can spin this story a number of ways and still generate an absurdity. If normal creditors and lenders cannot provide a reasonable story for their negative time value of money, we are left with an explanation that these negative rates are imposed on the markets as a form of financial repression by central banks.

This cannot continue. This is an easy comment to make, but one that does not help the investor who has to take action today. "The markets can stay irrational..." Still, investors should be looking for any uncorrelated alternative to this bond bubble.

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, by Omolola Veronica

In fixed income,

Bonds are expensive - Yet fighting irrationality is not easy

Cliff Asness - "Bonds are Frickin' Expensive"

As a boring economist, I will not use his colorful language, but the current fixed income world is not normal and bonds have gotten all the more abnormal over the last three months. Treasury 10-year bonds have seen their yields cut in half in a little over 6 months. Long bond rates are touching all time lows since the Financial Crisis even though we are not in a recession. Bond futures prices have skyrocketed with an increase of 20 points since March. The rally has been driven by outside capital buying higher US yields, a flight to safety for some investors, and speculative expectations of further Fed cuts. It does not matter who is driving the buying. Bonds are reflecting extreme expectations.

These extreme expectations are not just from strong short-term buying. Beyond price technicals, there are a number of fundamentals that point to expensive bonds. The term premium or excess yield necessary to hold longer-term debt has turned negative as measured by the NY Fed. These negative premia have been negative for over a year, and continue to trend lower. The yield curve has inverted based not just Fed tightness but on strong buying pressure at long durations that have pushed yields lower faster than the front-end of the curve. The yield on bonds are less than the cost of financing in the repo market, so the only reason to hold is based on expectations of further yield declines.

Inflation, albeit low, when subtracted from nominal rates suggests negative real returns. Real rates may go negative when there is a surprise shock to inflation or a central bank pushed rates lower, but these negative real rates is based on strong bond buying not inflation surprises. Looking at the relationship between the yield slope, real yields and industrial production, Cliff Asness argues for bonds being expensive. Industrial production does not justify the bond rally.

Unfortunately, we are not in a normal world nor is it likely to become normal in the near future. Investors have to accept continued irrationality and be bond buyers or assume the world will move to rationality, avoid bonds, and potentially miss what could be a great fixed income opportunity. We have seen this story before in Japan and Europe. Investors do not believe a bond rally can continue and only further rate declines. Investors are forced to make choices that would have thought unacceptable in earlier times.