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The Bond Market


Guest JoelS
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Buffett has been saying for years now that bonds are a quote "terrible investment". With inflation picking up and governments, including the USA, promising large infrastructure spending, are we closer to the end of this bond bull? Rates have gone up considerably over the past few months, but looked at within the broader context of history, perhaps the second and third leg is yet to come.

 

A few areas of discussion might be:

Thoughts on bond valuations

Could a bond collapse tip over into equities

Distressed debt

How would you structure a short bond trade.

 

All contributions appreciated.

 

Inflation: http://www.economist.com/news/finance-and-economics/21714375-deflationary-fears-are-last-point-being-banished-

 

Distressed debt market:

https://blogs.cfainstitute.org/investor/2014/10/30/who-will-suffer-from-a-leveraged-credit-shakeout/

http://www.grantspub.com/files/presentations/Fridson%20Spring%202014.pdf

 

Buffett:

http://www.reuters.com/article/us-berkshire-buffett-idUSBRE9450AO20130506

"Bonds, they're terrible investments now," Buffett said. "That will change at some point, and when it changes, people could lose a lot of money if they're in long-term bonds."

https://www.bloomberg.com/news/articles/2016-04-30/buffett-says-bonds-unattractive-if-not-terrible-for-reinsurers

https://www.youtube.com/watch?v=kFB8Tx_48po (from 6:15)

Lee Cooperman has said “Buying bonds is like bending down to pick up a quarter in front of a steam roller. what are your thoughts on that?”

Buffett: “I’m not even sure it’s a quarter.”

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I can only answer the one question. 

 

Could a bond rout tip over into equities?

 

Absolutely.  Think about all the connections.  Especially if inflation starts.  The bond market is 10 times the size of the equity market.  Bonds are held by certain companies, pension funds, money market funds, banks, and insurers.  When actual losses start to show up on the balance sheet, I think we see a slow motion crash as asset values adjust to a new lower growth reality. 

 

I will have more to add as I think about this. 

 

One thing is for sure.  I wouldn't want to be getting inauguarated this week.  Forces beyond the control of any government are at work. 

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You need to look at the relative valuation of bonds & stocks.  Every time we have had a large equity decline, the bond market provide an attractive alternative.  Damodaran has some interesting thoughts on bonds vs. stocks here:

 

http://aswathdamodaran.blogspot.com/

 

At a top level look bonds have a P/E of about 40.  So stocks are expensive relative to history but not interest rates.  There also tax cut & repatriation tail winds.  I think these are consistent with Buffett's thoughts.

 

Packer

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https://blogs.rhsmith.umd.edu/davidkass/uncategorized/warren-buffetts-meeting-with-university-of-maryland-mbams-students-november-18-2016/

 

Question 7:  What impact have the fixed income markets had on stocks?

 

WB:  Interest rates are to asset valuation as gravity is to matter.  It will take a lot of movement in interest rates (similar to Paul Volcker in 1981-2) before stocks are too high.  The interest rates on 30 year Treasury bonds have declined from 14 ½ % to 2 ½ % from 1982 to 2016.  Recently, the 30 year Treasury moved from 2.6% – 2.8%.  Stocks are cheap if long term rates are at 4%, four to five years from now.  “We are buying more shares than selling everyday unless interest rates move appreciably higher”.  A profitable trade would be to short the 30 year bond and go long the S&P 500 (assuming no margin calls).  But this is difficult to do on a big scale.  Borrowed money causes more people to go broke than anything else. Charlie Munger has said, smart people “go broke from liquor, ladies and leverage”.

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Fixed income (bonds & preferred shares) moves inversely to market interest rate. If you think interest rates are likely to rise, it’s a bad idea. To invest, is to make a call on how much rates change – and over what period.

 

Most recognize that existing rates are historically low, it’s artificial, & it’s been this way for some time.

Firms have generally used the opportunity to refinance at lower cost and extended term, raising profitability, and building equity.

 

But there has been little/no NET new investment in plant/investment. As old plant has become obsolete, or worn out – replacement new plant has been built, often in different global locations. To date this has been allowed to occur unfettered, but in the real world; old plant either gets state subsidized to keep the jobs, or tariffs are imposed on competing product to make them more expensive. But make a manufacturer replace obsolete equipment with state-of-the-art, & the state can reduce/eliminate subsidies/tariffs over time as labour transitions. Trump land infrastructure spending?

 

Most firms would borrow to invest, raising the demand for money, & the interest rate ‘cost’ of it (all good). However, the ‘cost’ of money was artificially lowered to promote this kind of activity; once infrastructure borrowing takes off, the central bank action can be eased. 2 big & independent sources driving up the cost of money – lowering the value of FI instruments. 

 

Your call as to how large that combined change is interest rates might be.

Your call as to how long it might take to occur.

 

SD

 

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Lacy Hunt: "it’s just more of the same.... I’m still long bonds, especially the long-end,"

 

https://www.bloomberg.com/news/articles/2017-01-18/bond-guru-who-called-last-bear-market-40-years-ago-says-go-long

 

Glad to see someone else who's watching velocity as their main indicator. This is why I'm still convinced deflation is the biggest threat and why I've started purchasing long-term, zero-coupon bonds again after having sold them in July.

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The economy is shifting to require far less capital while incomes amongst th rich is increasing rapidly creating excess supply of capital in a global capital market. Meanwhile capitalism and protection of private property is becoming rare concentrating capital into a few areas. So yields will remain low in places that have sensible policies same as the British empire enjoyed in the 1800s.

 

Rapid technological innovation plus capitalism will create strong deflationary pressure in we'll run countries. Poorly run countries, ie most places, will suffer weak currencies and inflation but wil export deflation as the world price of their goods decrease. Energy costs will soon plummet as numerous advances spread through competitive pressures. My favourite cheap power is the suncell producing pollution free carbon dioxide free power at 1/10th of a cent per kWh. It is the stated dream of global warmers and it will be fun to see global warmists squirm as they realize their dreams of strangling the economy with expensive energy and carbon taxes has a total and elegant solution first discussed in 1926 by a sculptor and painter who says he was told how the universe works by God (Walter Russell). What a delight to discover that God has a sense of humour!

 

Supply increasing and demand decreasing will keep rates low where capitalism and property rights continue to be protected. Low interest rates on the whole are beneficial as it limits the harms caused by usury.

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Lacy Hunt: "it’s just more of the same.... I’m still long bonds, especially the long-end,"

 

https://www.bloomberg.com/news/articles/2017-01-18/bond-guru-who-called-last-bear-market-40-years-ago-says-go-long

 

Glad to see someone else who's watching velocity as their main indicator. This is why I'm still convinced deflation is the biggest threat and why I've started purchasing long-term, zero-coupon bonds again after having sold them in July.

 

How can deflation be a threat with under 5% unemployment and a huge tax cut and stimulus on the way.

 

The decline in the velocity of money is just a consequence of the massive increase in base money. Velocity has gone down but only because base money has gone hugely up. All this tells me is that monetary policy is not working. There is a huge difference between the Great Depression where velocity went down because people actually bought less stuff and the current situation where people are still buying stuff but base money has increased due to the Fed buying bonds.

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