Explain bonds(markets) to me

[perulv]

Yes, the question is almost as naive as the subject indicates.

 

This question is related to all the news these days about a "bonds bubble", negative interest rates etc.

 

In my simple world, a bond was something you bought and and collected "interest" on. I do understand that they have a market price, different quality/riskiness have different yields and you can speculate in the price-changes (e.g. buying them on the cheap during the 2008 financial crises, the proverbial 60 cents to a dollar).

 

What I do not get, is stuff like this:

The tweet says it all I guess, "Investors bet that they will be able to sell the bonds to the next fool at a higher price.".

 

But if I read this correctly, "the market" pays 180 euro for an instrument that will pay you back 100 euro, and in the meantime yield... nothing?

If so, it seems pretty obvious that this has a great chance of falling back to 100 ish... but is it that simple? In general, when I look at something and figure "hah, everyone else are idiots", there is something I'm missing :) The market tends to be relatively rational, at least more often then I would like it to be.

 

There are tons of articles about the "trillion dollar bubble" (https://www.bloomberg.com/news/articles/2019-06-26/trillion-dollar-monster-lurks-as-bonds-price-out-duration-risk).

 

I find it hard to believe that fund managers around the world are buying 100 dollars for 180. What am I missing? And if they were, would it matter if the interest-rate moved in one way or the other (triggering sell-off, as some articles hint at), as the price is so totally detached from the underlying value anyway? Is the fear that investors will wake up and understand that this is crazy, and start selling? What would be the direct and indirect consequences for the equity-investors in (presumably) high quality companies with relatively little debt?

 

Or is the bubble on the other side of the table, the fact that corporations have taken on an enormous level of debt?

 

I would really appreciate your insights.

[wachtwoord]

Institutions that hold lots of "cash" (e.g. banks) have to store it somewhere. They think (on aggregate) a guarenteed loss on the bonds is superior to the alternatives.

 

Additionally, the rates are really only this low becausecof central bank inteference (primarily QE). People need to accept we don't have a free market (in fact, at least since the inception of central banks, we never did).

[Cigarbutt]

Disclosure: not a forecast, just a comment about potential downside risk.

 

We have recently lived in a world of low (although slowly declining) and quite stable inflation and have got used to it. It seems that (extreme) non-linear circumstances can occur at the (extreme) margin.

 

During the Weimar hyper-inflation episode, people, on their way to work in the morning, would bring their bags of money to buy bread and not wait for their return at the end of the day because the price would have increased significantly in the interim.

 

During deflationary episodes, people learn to postpone buying and investing as they expect things to get cheaper (people buying bonds now seem to expect somehow that their real purchasing power may be higher when the bond is eventually redeemed at face value). This may give rise to a paradox of thrift and it then may become unusually difficult to awaken animal spirits.

 

By inverting, if I were a central banker, what would I do to cause a significant deflationary episode? I would institute and repeat easing programs and contribute to the debt overhang. But who said that central banks should be contrarians?

[mcliu]

Random thought:

Maybe, you can still achieve positive returns when you buy bonds at 180% of par.

Just sell it to the ECB for 190%.

The ECB can be the "greater fool" of last resort.  ::)

[thepupil]

I'm not aware of many (any?) fund managers buying negative yielding debt. It's all institutions that have non-economic motivations (central banks, banks for regulatory reasons, etc).

 

A notable instance of economically minded investors owning negative interest rate debt is anyone who owns an international bond index fund.

 

https://investor.vanguard.com/mutual-funds/profile/overview/vtabx

 

For example, VTABX has an SEC yield of 0.45%, a maturity of 9.7 years, and duration of around 9 ish as well, that's because it owns a bunch of JGB's, bunds, etc. So there's an example of $130 billion of folks retirement money that is investing in this stuff.

 

[Ross812]

I'm not aware of many (any?) fund managers buying negative yielding debt. It's all institutions that have non-economic motivations (central banks, banks for regulatory reasons, etc).

 

A notable instance of economically minded investors owning negative interest rate debt is anyone who owns an international bond index fund.

 

https://investor.vanguard.com/mutual-funds/profile/overview/vtabx

 

For example, VTABX has an SEC yield of 0.45%, a maturity of 9.7 years, and duration of around 9 ish as well, that's because it owns a bunch of JGB's, bunds, etc. So there's an example of $130 billion of folks retirement money that is investing in this stuff.

 

To be fair, the SEC yield is pretty meaningless for VTABX because the majority of bonds it holds pay annually in December. The SEC yield is based on the last payment of 0.0207 paid on 8/1 projected over the year. Last December's payment was 0.438. The SEC yield will be 20% plus in December ;-) .

[thepupil]

Looking at the bonds the fund holds, don't see a bias toward december pay bonds at all. the yield to maturity was 0.7% as of 6/30, which is stale because prices have gone up and yields going down.

 

I think the yield to maturity is somewhere between 0.4% and 0.7%, perhaps, 0.6 or something. The overall point stands.

 

If you index in the bond market outside the US, you're buying negative yielding debt.

 

This is a problem with Target Retirement funds, in my view.

[Jurgis]

If you index in the bond market outside the US, you're buying negative yielding debt.

 

Bond market indexing makes much less sense overall compared to stock market indexing.

[perulv]

I'm not aware of many (any?) fund managers buying negative yielding debt. It's all institutions that have non-economic motivations (central banks, banks for regulatory reasons, etc).

 

A notable instance of economically minded investors owning negative interest rate debt is anyone who owns an international bond index fund.

 

https://investor.vanguard.com/mutual-funds/profile/overview/vtabx

 

For example, VTABX has an SEC yield of 0.45%, a maturity of 9.7 years, and duration of around 9 ish as well, that's because it owns a bunch of JGB's, bunds, etc. So there's an example of $130 billion of folks retirement money that is investing in this stuff.

 

So.... the bond itself "should" yield close to (actually less than) nothing. But when I (as a random person with no financial skill) look at my pension-savings, I see that this presumably super-safe investment is up 10% in a year. Is that part of the "bubble"-factor here?

 

Institutions that hold lots of "cash" (e.g. banks) have to store it somewhere. They think (on aggregate) a guarenteed loss on the bonds is superior to the alternatives.

 

Additionally, the rates are really only this low becausecof central bank inteference (primarily QE). People need to accept we don't have a free market (in fact, at least since the inception of central banks, we never did).

 

This is interesting. As a bank I _have_ to put these billions (for capital requirements) somewhere, and there are strict regulations on what instruments. So I have to put them into these "safe" instruments, even if I fully realize that the current price (vs value) of these instruments are way high.... unless there are accounting-rules for how to value these (different from the price), could't that mean that when the price at some point aligns with the value (par?), the bank is suddenly a few billions short of their capital requirement  :o

[RuleNumberOne]

perulv,

 

You are exactly right in both your posts. Bloomberg has 3 articles in today's edition saying the same thing.

 

One of the Bloomberg articles calls it the dot-com moment for the bond market. I have been posting the same thing for the last few months at CoBF.

 

The Austrian 100-year bond has already climbed to 191 (it was 180 in your first post). If it goes back to 100 it is a big loss.

 

In today’s bond market, it seems as if no price is too high.

https://www.bloomberg.com/news/articles/2019-08-07/the-furious-global-bond-market-rally-shows-few-signs-of-abating

 

The ECB Is Dragging Us Deeper Into Madness

https://www.bloomberg.com/opinion/articles/2019-08-08/ecb-is-dragging-the-bond-market-deeper-into-yield-curve-madness?srnd=premium

 

This Might Be the Bond Market’s Dot-Com Moment

https://www.bloomberg.com/opinion/articles/2019-08-08/this-might-be-the-bond-market-s-dot-com-moment?srnd=premium

[Jurgis]

I'm not aware of many (any?) fund managers buying negative yielding debt. It's all institutions that have non-economic motivations (central banks, banks for regulatory reasons, etc).

 

A notable instance of economically minded investors owning negative interest rate debt is anyone who owns an international bond index fund.

 

https://investor.vanguard.com/mutual-funds/profile/overview/vtabx

 

For example, VTABX has an SEC yield of 0.45%, a maturity of 9.7 years, and duration of around 9 ish as well, that's because it owns a bunch of JGB's, bunds, etc. So there's an example of $130 billion of folks retirement money that is investing in this stuff.

 

So.... the bond itself "should" yield close to (actually less than) nothing. But when I (as a random person with no financial skill) look at my pension-savings, I see that this presumably super-safe investment is up 10% in a year. Is that part of the "bubble"-factor here?

 

 

Let's say you have bond priced at 100 yielding 1%.

Let's say you believe that this bond should be priced to yield 0.5% based on similar assets/whatever.

What would be the price of the bond based on your expected yield assuming perpetual bond for simplicity?

 

Yes, 200.

 

What is the yield difference of such bond when the price goes from 180 to 190 (up approximately 5+%)?

 

Yield at 180 is 0.55%

Yield at 190 is 0.526%

 

So for yield drop of 0.025%, the bond price goes up 5%.

 

You can call it bubble or whatever, but that's the math. Clearly the math also applies in the other direction (what should be the price of the bond that currently is priced at 200 and yields 0.5% if you believe it should yield 1%? Yeah, 100.)

 

 

It gets more complicated for non-perpetual bonds, but I hope you got the picture.  8)

[perulv]

Let's say you have bond priced at 100 yielding 1%.

Let's say you believe that this bond should be priced to yield 0.5% based on similar assets/whatever.

What would be the price of the bond based on your expected yield assuming perpetual bond for simplicity?

 

Yes, 200.

 

 

First of all: thanks for taking the time to explain this.

 

Intuitively, this made no sense to me. Why should an instrument with half the "payout" be worth twice as much? But I guess I'm confusing the terms yield, coupon rate, and perhaps discount rate.

 

I guess this would be similar to, or is in fact the same, as lowering the discount-rate in a present-value calculation? with a small enough discount-rate, the present value would be arbitrary large. I would probably be foolish to use that number to do any investing, though...

 

But what is the definition of "a bond yielding 1%" here? Is the calculation: a $100 bond with a coupon rate of 1%, priced at $200, is priced to be yielding 0.5%? That kind of sounds like saying "I value this stock at twice <whatever price>, because I believe the p/e multiple should be twice as high". Which I guess is the same, since half the current discount-price means twice the price current price.

 

Still... stocks can grow into their valuation (the e can increase), while the coupon rate cannot. Even if I get the math here (and please correct me on the above ramblings if not), not sure I get the sanity of it.

[Jurgis]

Let's say you have bond priced at 100 yielding 1%.

Let's say you believe that this bond should be priced to yield 0.5% based on similar assets/whatever.

What would be the price of the bond based on your expected yield assuming perpetual bond for simplicity?

 

Yes, 200.

 

 

First of all: thanks for taking the time to explain this.

 

Intuitively, this made no sense to me. Why should an instrument with half the "payout" be worth twice as much? But I guess I'm confusing the terms yield, coupon rate, and perhaps discount rate.

 

I guess this would be similar to, or is in fact the same, as lowering the discount-rate in a present-value calculation? with a small enough discount-rate, the present value would be arbitrary large. I would probably be foolish to use that number to do any investing, though...

 

But what is the definition of "a bond yielding 1%" here? Is the calculation: a $100 bond with a coupon rate of 1%, priced at $200, is priced to be yielding 0.5%? That kind of sounds like saying "I value this stock at twice <whatever price>, because I believe the p/e multiple should be twice as high". Which I guess is the same, since half the current discount-price means twice the price current price.

 

Still... stocks can grow into their valuation (the e can increase), while the coupon rate cannot. Even if I get the math here (and please correct me on the above ramblings if not), not sure I get the sanity of it.

 

I'm not saying it's sane, but there might be reasons why it's not completely insane either.

 

thepupil gave some examples of why someone buys even negative yielding debt. Presumably if there's a choice of buying negative yielding debt and the debt yielding 0.5%, the buyer would buy the latter one (all else being equal of course - this is simplified example). All else being equal, you're likely to put money into a bank that pays you 0.1% rather than bank that pays you 0.01% even if neither 0.1% nor 0.01% are meaningful in terms of returns.

 

Finally, assuming you knew that rates will go down to 0.25% in the future, you'd probably buy the bond that yielded 1% yesterday driving its price up 2x to 0.5% yield today.

You might say "this is insane". But people who did it at 7% are laughing all the way to the bank. Then the people who did it at 4% are laughing all the way to the bank. And even people who did it at 2% are right so far. At some point the buyers will be wrong. But I doubt you or people on CoBF really know when this will happen and how.

 

Still not saying this is very sane, but is it completely insane? I'll let others argue for and against.  8)

 

Here's Bloomberg's argument of why this might be sane:

 

https://www.bloomberg.com/news/articles/2019-08-08/the-non-weirdness-of-negative-interest-rates?srnd=businessweek-v2

 

[perulv]

I'm not saying it's sane, but there might be reasons why it's not completely insane either.

 

thepupil gave some examples of why someone buys even negative yielding debt. Presumably if there's a choice of buying negative yielding debt and the debt yielding 0.5%, the buyer would buy the latter one (all else being equal of course - this is simplified example). All else being equal, you're likely to put money into a bank that pays you 0.1% rather than bank that pays you 0.01% even if neither 0.1% nor 0.01% are meaningful in terms of returns.

 

 

Sure, this makes sense. "I have all this money, I can't very well put it in the madras. So even if I have to pay for someone to store it safely, I'll do it. And btw, I think the rate will get more negative, so I'll lock in this "profit" at this rate". That is just a conservative investment, like a person using a high interest rate instead of a mutual/index-fund for savings. Nothing "bubbly" about that, just lost opportunities.

 

But that reasoning only makes sense as long as the price for the bond is close to the par value, right? If I do the above reasoning, and put my money in a bond priced at $200 with a par value of $100, my downside is (at least) 50%, and I am far into the more speculative area you describe in your second paragraph:

 

Finally, assuming you knew that rates will go down to 0.25% in the future, you'd probably buy the bond that yielded 1% yesterday driving its price up 2x to 0.5% yield today.

You might say "this is insane". But people who did it at 7% are laughing all the way to the bank. Then the people who did it at 4% are laughing all the way to the bank. And even people who did it at 2% are right so far. At some point the buyers will be wrong. But I doubt you or people on CoBF really know when this will happen and how.

 

Still not saying this is very sane, but is it completely insane? I'll let others argue for and against.  8)

 

Here's Bloomberg's argument of why this might be sane:

 

https://www.bloomberg.com/news/articles/2019-08-08/the-non-weirdness-of-negative-interest-rates?srnd=businessweek-v2

 

 

The fascinating thing to me is that it seems the first part (conservative placement of money) can sorta drift into the second. The bank that is bound by law to invest its reserves in some types of bonds, or the conservative and dull fund that my mother thinks acts like a savings-account (yielding a small but steady return), is suddenly becoming a speculation with significant downside.

 

(it got a bit tiresome to put in all the "I guess"-es, so even if the above is written as facts, I´m still very much inquiring open for insights :))

[Jurgis]

But that reasoning only makes sense as long as the price for the bond is close to the par value, right? If I do the above reasoning, and put my money in a bond priced at $200 with a par value of $100, my downside is (at least) 50%

 

Right.

 

Just remember that even if you buy bond at par value, your downside can be 50% or more if either you won't keep the bond to maturity or it defaults or inflation destroys your terminal value.

 

But sure, buying at 2x par adds to risk. I just omitted that since return calculations become more complex.

[Guest cherzeca]

aren't most negative yield instruments European sovereign?  isn't the ECB saying that it will buy this debt at this price to avoid another Euro credit crunch? isn't this preferable to the Germans than having a common credit EU bond (Greece issue same bond as Germany)...which is where some in the EU were going last time of the EU crisis?

[RuleNumberOne]

https://www.investopedia.com/terms/y/yieldtomaturity.asp

 

The above link has what you need. There are two things you get when you buy at 191:

 

1. The haircut of 91 when you get back the face value of 100 euros a 100 years from now.

 

2. The coupon of say 2 euros per year.

 

These are discounted back using the "yield-to-maturity". This yield-to-maturity has turned negative for upto 30-year debt. The longer the maturity the greater room for speculation.

 

Italy issued 50-year bonds.

 

Yes, it is absolutely batshit crazy. Negative yielding bonds (in a currency which likely wont exist 100 years from now) and negative yielding stocks (like WeWork) are preferred over dividend-paying stocks like WFC.

[Cigarbutt]

Additional comments (are investors putting cash in negative-yielding debt stupid or prescient?):

 

Historically, especially if you have to match long-term liabilities and have to think long term, the total return from bonds has come from income (coupon) and not capital appreciation. Many people have looked at this and it seems that it is reasonable to assume that, under normal circumstances and even during a period of declining interest rates such as happened since the early 80's, more than 90% of the return has come from income. Here's a typical reference:

https://www.brandes.com/docs/default-source/brandes-institute/2015/income-as-the-source-of-long-term-returns.pdf

 

So, there are exceptions and individual decisions about what bond to buy/sell and when matter but, typically, the main driver of future returns for bonds is the starting yield. So, what are these investors thinking when the starting yield is negative? Apart form the expectations about low or lower inflation levels, there are instances when the bond investor expects that the capital appreciation component of total return will continue to occur, as has been the case recently, even in a negative interest world. Another possibility is for bond investors to benefit from "rolling down" maturing bonds in certain sloping environments. Japan provides an interesting example (at least up until recently):

https://blog.pimco.com/en/2016/04/a-surprising-experience-with-bond-returns/?_ga=2.87817880.1417941211.1565353948-1114108504.1525365177,2.87817880.1417941211.1565353948-1114108504.1525365177

But financial asset japanization is a contained disease. Right?

 

What terrifies me (from the investing point of view :) ), is not that these negative-rate bond investors are stupid, it is that they may be correct.

 

Concerning cherzeca's comment about the financial sustainability of the union, I always thought that one of the underpillars of the Maastricht Treaty was that completing successfully the project required fiscal consolidation. At least, that's what Mr. Soros has maintained for so long. Is he just an old crying wolf?

[mcliu]

Cigarbutt's post makes sense. The conventional wisdom is that when you buy a negative-yielding bond (pay a big premium to par), your return will be negative. That's only true if you hold to maturity. In the meantime, with the ECB/BOJ buying ever more and more bonds, there's opportunity to flip bonds to them for a positive return. (Which is probably the intended effect.)

 

In essence, the central banks are bailing out bank shareholders by inflating asset values instead of doing a restructuring/capital-injection like in the US/UK.

[Guest cherzeca]

"one of the underpillars of the Maastricht Treaty was that completing successfully the project required fiscal consolidation."

 

this in my view will never happen, because Germany will not permit it. from Germany's (virulent anti-inflation) point of view, stagnation and receession are preferable

[RuleNumberOne]

How would Germany tell its voters that you have to work and save in order to pay the pensions of retirees in Greece, Italy, Spain.

 

Fiscal consolidation will never happen. Can you get US voters to pay pensions of Mexican or Canadian government employees?

 

"one of the underpillars of the Maastricht Treaty was that completing successfully the project required fiscal consolidation."

 

this in my view will never happen, because Germany will not permit it. from Germany's (virulent anti-inflation) point of view, stagnation and receession are preferable

[RuleNumberOne]

Italy 10-year yields jumped 24bp in today to 1.77%.

 

Because Salvini is calling for new elections.

 

Italy needs to exit the Euro and end their humanitarian disaster. Debt to GDP higher than ever, 3 recessions in 10 years, 33% youth unemployment.

 

ECB and Eurocrats have a great lust for power and have created a big bond bubble just so that they can cling to power for some more time. Their pensions and savings need to be zeroed out and clawed back, just like they came after private sector banks in 2009.

[Guest cherzeca]

"Their pensions and savings need to be zeroed out and clawed back,"

 

this also will never happen imo.  the EU is fascinating since it is a (failing) social science experiment in real time.  all of the options that are calculated to remedy the inherent flaws of a single currency/separate credit issuers system will be beyond the pale for the EU bureaucrats...inasmuch as their jobs as EU bureaucrats require maintenance of status quo, on the one hand, and Germany on the other hand. things have gotten so extreme that the ECB has completely dominated the financial scene, which of course predictably has eliminated rational private actor price discovery (hence private actors doing something like buying negative interest rate sovereign bonds which is clearly irrational).  the EU credit market has become stalinist in certain ways (top down domineering, emperor wears no clothes).

 

this absurdity can last a long time however as I think the only way out is significant political turmoil, and if there is one thing the EU bureaucrats can do, it is bribe countries to quell this turmoil.

 

EDIT:  and the topper is that the next ECB chief will be a rank bureaucrat, a pol who looks at financial issues with political-colored glasses.  wonder how that goes?

[scorpioncapital]

If the EU is united, then there is nothing wrong for germany to pay the pensions of other nations in part. just like in canada alberta sents 10 billion of transfer payments to slightly more bankrupt quebec...but europe is not na. each nation is extremely selfish although being part of the so called 'eu'. it is not really a union like the USA, or even canada...however i would say the eastern countries of the EU, the former communist countries are doing very well and actually are a very desirable place to live vs the western parts. it's not all one uniform bloc. these eastern additions to the EU that don't use the euro have reasonable inflation around 3 to 4% and are quite dynamic markets.