Monday, June 21, 2010

The Low Bond Yield Conundrum (Reprinted)

This is an edited reprint from November 19, 2006 which demonstrates what large swings in interest rates can do of the bond market. Note the interest rates are off a bit; at the time of writing, there was less than 100 basis points between the 30 year Treasury bonds and the one year T-Bills. The 30 year interest rates have remained constant, the short term rates have gone to hell. Greenspan was the man in charge at the time.


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 may not seem obvious, but as the price of a bond drops, its interest rate increases and vise versa). The Baby Boomers could be going to less risk in their portfolios. An insurance company locking in rates on an annuity for thirty years, this would be a smart call.

Where it gets kinky, is the fact that everyone is loaning 30 year money at close to the rate paid for the one year Treasury. Look at a 30 year bond issued today at say 5%.

Value of Face amount-------interest rate--------interest paid
----$1,000,000-----------------5%-----------------$50,000

No problem with the investment, but if the interest rate went to 10%, the dynamics change. Using that same 1,000,000 bond we now have:

Value of face Amount-------interest rate--------interest paid
------$500,000------------------10%-----------------$50,000

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. (Note if you were to buy at 10% and it swung even lower to 20%, your jaw could hit the floor rather hard.)

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 if not pathetic).

We seem 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 them 30 years to fully appreciate. Your clients only have 15 to 35 years to live. They just might need the money before the call date. The real culprit is unperceived inflation --your monthly retirement check might only buy a weeks worth of groceries. I guess this is how you get "saved" from a severe deflationary spiral--more government printing.

The Conundrum is, why invest in bonds? You're guaranteed a loss at present interest rates.

15 comments:

Sackerson said...

Hi, Jim. My thoughts also. But the US & UK are in such a jam that I expect they will do anything to keep the interest rate down. Our new Chancellor will certainly produce a v tough budget to reassure the bond market. Maybe the US can't do the same, but I shouldn't bet on it - the notion multitrillion dollar debt would be altered if benefits were reduced, pension contributions raised etc. It's "sh** or bust" - do you expect the latter?

mikewarot said...

This is exactly why I moved my 401k money out of bonds last week. 8)

Anonymous said...

Bonds and stocks have been destroyed by inflation and taxes. The liquidity that has come and will continue to come in is the final nail in the coffin. US "lost decade" #1 is over, get ready for lost decade #2.

And without any new technology or innovation don't expect jobs or wages to go up = residential real estate isn't going to appreciate. You can say the same for commercial real estate as well (except for maybe apartment buildings--where all the disenfranchised and foreclosed upon home owners and salary cut or part time employed are going to have to live).

Nothing to invest in, other than yerself (health, education, new skills).

Jim in San Marcos said...

Hi Sack

Welcome back.

I think that the low interest rates are a sign of fear. Everyone wants a safe harbor for their savings. Both of our governments are borrowing and printing money. The general population isn't borrowing money and those that do want to borrow, probably can't qualify for a loan.

The government is taking advantage of the low interest rates, it kind of reminds me of the symptoms of a tidal wave, first the water recedes and everyone runs out to pick up the floundering fish.

It's the rising interest rates that will kill us. Add on all of the promised pensions and health care benefits, you have the makings of a real mess.

I think that the real barometer for inflation will be food prices. You can't print food.

Realistically I see retirement and health care benefits reduced 75% when this mess is over. Worst case, could be zero. The neat thing about that is that the old farts, like me, are to old to revolt and overthrow the government. They will be advised to suck it in and go some place and die.

When you really think about it, your kids are your retirement policy. The government programs were just a way of collecting it from your kids. Now it's going to be more personal, you'll have to ask.

Take care

Jim in San Marcos said...

Hi Mikewarot

I'm still waiting, I have my 401K in short term bonds. I'm waiting for the Stock Market to tank and then switch over to stocks.

Not sure that it will happen, but bonds are going to be a place, to be from, and not a destination. Rising interest rates could be an indicator to watch.

Thank you for your comments.

Jim in San Marcos said...

Hi Anon 2:06

Its not as bad as you suggest. The world isn't coming to an end any time soon.

You need to realize, that you can buy a mansion in Michigan for $15,000. There are deals everywhere and they are getting better every day. A 100K sail boat can be bought for 20K (I'm looking for one)(hope the wife doesn't read this).

We are in a transition, there is no real demand to build homes like crazy. So there are a lot of people that have to retrain.

As you suggest, you can't go wrong in investing in your education.

Take care and I wish you the best of luck.

antknee said...

You came to the right guy with a yield article since I sell large amounts of US Treasuries to institutional clients… first… This article is poopy c0ck. Do the math, stick it in excel. Even if you use a 30 year UST (the longest maturity treasury we have) and you assume a 10% coupon every year for 30 years. At an interest rate of 10% you have a bond with a present value of $100. Makes sense right? Even if you cut that interest rate in half to 5% the bond is now worth $176. Now that A) rates are cut in half and B) that you’re talking about a 30yr treasury. Do the same exercise with a 10yr and you go from 100 to 138. Consequently the loss profile looks roughly the same in the other direction. More risk in a longer dated security for an equal move in interest rates. And if you take into account where 30yr bond yields are right now… Approx 4.10% if you take 30yr treasury trading at par ($100) and cut the rate in half to approx 2% you only get an appreciation to $146. We hit 2.5% in the long bond in the same quarter we printed -6.5% GDP growth and deflation wasn’t just a threat it was happening. So… not say we couldn’t get there again and there are plenty of people who think we can, but when we get a 3.8% GDP print in July for Q2 it’s going to be tough to justify any cutting in half of rates. Poopy c0ck

Griffin T. said...

I guess I'm not surprised rates are so low considering consumer sentiment and many investors' flight to safety. I wonder how Bond rates compare to CD rates?

Joseph Oppenheim said...

The Conundrum is, why invest in bonds? You're guaranteed a loss at present interest rates.<<<<<

Because investing in TIPS has been very profitable for me, plus they continue to offer both protection against deflation and inflation. Deflation, because I buy when they sell below par value. Even those which sell for a little above par still offer such protection.

They remain a part of my diversified total portfolio.

By the way, my net worth is higher than when all this financial mess began, actually at an all-time high. Not bragging, just showing that this has actually been a very good time for a private investor.

Jim in San Marcos said...

Hi Antknee

Let me give you an examle.

A fund manager locks in a million dollar face Bond at 3% for 30 years and it will pay 30K per year in interest.

If interest rates went to 6% a person could lock in a million dollar 30 year bond paying 60K.

If interest rates went to 12% a bond locking in at that rate would pay 120k interest each year.

If interest rates were at 12% and you needed to raise cash by selling your 3% 30 year bond, you won't get more than 300K for it.

There is an excel formula for determining the equivilent cash value of any bond given the face amount, interest rate of the bond, current rate and years left on the bond.

The issue right now is the absurdly low interest rates long term, it makes no cents (sense) with the present rate of inflation.

dearieme said...

Here's a view on future US inflation.
http://www.investorschronicle.co.uk/Columnists/ChrisDillow/article/20100623/0fb7857a-7ea7-11df-ae99-00144f2af8e8/Americas-fiscal-inflation.jsp

Jim in San Marcos said...

Hi Griffin T

I really wonder why anyone buys bonds or CD's. They pay just about zip.

Bonds usually pay a little more, that is money committed for over a year. CD's are real short term and some of those pay .2%!

I don't see any incentive to save with such low rates, inflation has to be at least 3%.

Jim in San Marcos said...

Hi Joseph

I wonder about TIPS a bit. The wolf is in charge of the chicken house here. Our government determines the inflation rate. Food and everything else that has taken off in price, has been dropped from inflation calculations.

My portfolio is doing good also, only because of diversification. Every investment has its day.

Thank you for your comments.

Jim in San Marcos said...

Hi Dearieme

Thank you for the link. The future looks grim. Inflation is already here; onions are $1.60 a pound now.

Take care.

Arixa Capital said...

ndividual trust deed investments are relatively small when compared to government or corporate bond issuance. For this reason it would be difficult for large institutional investors to put a lot of money to work into trust deeds. Therefore, the trust deed market is left to smaller investors who also have the expertise to distinguish good trust deed investments from bad ones. It turns out that the universe of such investors is fairly small compared to the universe of borrowers who are seeking private money loans.

The combination of limited supply and high demand results in a high price—in other words, a high yield for trust deed investors.

Additionally, many investors place a high value on liquidity — being able to sell investments quickly and convert them into cash. Corporate and government bonds are some of the most liquid investments in the world. Trust deed investments on the other hand cannot be converted into cash quickly. This lack of liquidity contributes to the higher yield of trust deed investments.