Sunday, November 19, 2006

The Low Bond Yield Conundrum

The bond market is at a point right now that leaves an awful lot of long bond holders (buyers of the 30 year) very vulnerable.

With the coming vaporization of the second trust deed market, there should be a scarcity of funds. Add to that, marking to market of foreclosed homes adds even more to this up and coming "enterprise." Seventeen interest rate increases by the fed and the long term rate comes out very little changed.

In Greenspans speech to Congress last year June 9, 2005 he is quoted:

Among the biggest surprises of the past year has been the pronounced decline in long-term interest rates on U.S. Treasury securities despite a 2-percentage-point increase in the federal funds rate. This is clearly without recent precedent. The yield on ten-year Treasury notes, currently at about 4 percent, is 80 basis points less than its level of a year ago. Moreover, even after the recent backup in credit risk spreads, yields for both investment-grade and less-than-investment-grade corporate bonds have declined even more than Treasuries over the same period.

What it really boils down to is; there is a very large demand for long term bonds. More than the market can supply. Otherwise interest rates would rise to attract buyers (this is backwards, the price of the bond drops and that raises the interest rate). The Baby Boomers could be going to less risk in their portfolios. An insurance company locking in rates on an annuity for thirty years is a smart call.

Where it gets kinky, is the fact that everyone is loaning 30 year money at about par for the one year note. lets look at a 30 year bond issued today at say 5%

Value of Face amount-------interest rate--------interest paid

No problem with the investment, but if the interest rate went to 10%, the dynamics change. Now we have:

Value of face Amount-------interest rate--------interest paid

What this shows, is that your market portfolio could, if marked to market have a haircut of 50 percent. Notice however, if you hold on to maturity, there is no "real" loss of principle. 30 years is a long time to wait if you are already 60 (I turned 60 yesterday).

The real pure play for the bond market is to buy when the market is at 10% and sell when it goes to 5%. That play, a reverse of the first example, would net a cool half million. This is where the money is made in the bond market.

The only thing that makes today a buying opportunity, is the belief that the interest rate will drop to 2.5%, this would double your bond portfolio's value, and it just ain't going to happen.

Another thing that Greenspan mentioned, that people were willing to accept more risk with less reward. Everything except Delta Airlines Bonds are trading as if they are US Treasury's (admittedly an exaggeration, but the rates commanded are rather unrealistic).

Its only a personal opinion, but I believe that we have a market running on the herd mentality of "If it works, go with the flow." At some point there will be a demand for funds that could raise the interest rate to quite a spectacular level, even if for a short period of time. It is at that point, that cash can buy into the bond market and make a killing.

A stock has to double to double your money. With a bond a 50% drop in the interest rate doubles your return. The thing to remember in a panic, it's like going into a pawn shop with a $10,000 wedding ring, you're not going to get list price or anywhere near it. You're are going to take what you can get according to how desperate you are for cash funds.

What you really have, is a mistake being made by retirement funds, that will take 30 years to come out even. Your clients only have 15 to 35 years to live. They just might need the money before the call date.


Anonymous said...

where do you get your info...No insurance company invests in the LONG BOND...In fact the 30 year bond is fairly illiquid compare to other bonds...Furthermore it was only brought back to the mkt last year for non us investors...

Also, you seem to confuse short rates and long rates...?

Jim in San Marcos said...

There might be some misunderstanding here, I was pointing out the absurdity of buying the 30 year bonds and only suggested that an Insurance company purchasing one to cover an annuity made any sense to me.

I don't understand what you mean by "you seem to confuse short rates and long rates?" There is no real difference between the two right now that would be an incentive to take on the added risk of the 30 year bond.

I could hazard a guess as to who is buying this junk, and it would have to be one of two Asian governments.

Another ploy, since Islam considers interest, religiously sinful, the Arabs might be buying the bonds to dump on us at time of their choosing, to help cripple the "Great Satin." Highly improbable, but worth a laugh

Numpty McHoon said...

One happy belated birthday to you Jim. Mucho appreciado.

I found your blog thru bubbletracking and have spent the morning reading up to here.

You make compelling reading of a subject that normally puts me to zzzzz.

I'm fifty this year *groan* and since selling my house in '05- it seems like I did good- now I'm faced with investing decisions for the first time in my life (poor working stiff me).

Thus the interest.

N from El Lay