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The bond crash: Is this it?

A friend and I once debated the meaning of Is This It, the opening salvo of New York punk miserablists The Strokes.

When I listened to the song, I heard a singer lamenting how he’d stepped over the long-awaited threshold into adulthood, only to discover that being grown-up mainly consisted of sitting around in half-arsed house parties saying everything was rubbish before trying to get off with whoever was left after the trains stopped running.

Ho hum.

My friend’s take was different. She heard two lovers realizing it was over. Their moment had come, and this was It.

Actually she was sort of more a girlfriend. And then we sort of split up.

Anyway… I thought past my meandering love life to remember this song and that debate over the weekend as I pondered the bond market.

Because dear readers, it seems the end of the bull run for bonds might just have begun.

Or at least that the delirious love affair is over.

Is this it?

If you’ve been paying attention to the markets recently then, well, you haven’t been paying attention to my co-blogger.

Monevator’s index fund champion rightly says you should ignore market noise, invest passively [1], and take up a less hokey hobby such as astrology.

Of course, I think you should do that, too.

But then I am – according to said co-blogger – the “Captain Jack Sparrow of investing”.

Which, incidentally, is definitely the greatest compliment I’ll ever receive this lifetime (initially prompted by mention of my “deviant wild side” over on a new [2] UK money blog).

What I think they mean is I turned dark [3] long ago.

I invest actively as opposed to passively for my sins, and I’ve been watching the recent volatility in the bond markets with a mixture of interest, glee, and a little bit of dread.

Surfs up at Bond(i) Beach

Here’s a taste of the turmoil courtesy of The Wall Street Journal [Search result [4]]:

Markets are being convulsed by the latest collision between two grand, opposing forces: the soft demand for goods and services that has hamstrung economic growth and forced down interest rates in practically all the world’s large nations, and the expansive central-bank policy that officials from Europe to Japan and China are deploying in a bid to bolster anemic spending and investment.

The collision has fueled a sharp upswing in volatility, reflecting large price swings as investors scramble to position themselves for perceived changes in the economic outlook following large price increases in many stocks, bonds and other assets.

Quite the drama! The yield on the German 10-year bund has doubled in just a few weeks, for example, albeit off very low levels.

Indeed it’s a sign of how weird the times are that the German 10-year yield soaring to the lofty heights of 1% and its US equivalent approaching 2.5% has caused all this anxiety.

If you’re a newcomer to investing (or you’ve just not seen many long-term graphs [5]) you might need a reminder about just how unusual these very low rates of recent years have been.

Check out this graph of the US 10-year’s yield over the past 150 or so years:

US 10-year yield over the long term (Click to enlarge) [6]

US 10-year yield over the long term (Click to enlarge)

Source: Multpl [7].

See the massive spike in yields that’s now causing so much hand-wringing?

No?

It’s on the far right of the graph.

It’s that tiny red blip that you’ll need to enlarge the image to see, and then move your head in until you’re three inches from the screen…

Anyway, as you’d expect my active investing supercomputer mind has been whirling through what this all means and calculating the second-by-second trades that I should make in order to own the optimal portfolio.

Either that or I’ve just been watching and pondering the fun to come if and when rates do rise a lot, the tide goes out, and as Warren Buffett says we get to see who has been swimming without their Speedos.

(Hey, that Captain Jack Sparrow comparison doesn’t just attach itself like a snowflake in wintry shower. You have to earn it in a blizzard [8]!)

Take it on the chin

So Is This It? And if so, what should you do about it?

Well, let’s think back to that Strokes’ song.

If you’re a passive investor, your attitude should be something akin to my interpretation of the singer’s predicament.

In other words, The Strokes would say you should shrug your shoulders, admit that investing life has its ups and downs, and accept that if This Is It then your bond returns are going to be lousy for a year or three but your shares might make up the difference. They usually – but not always – do.

It can be painful to hold an asset when it starts going down. But remember that as a passive investor you don’t pretend to know when such a move will start or stop.

Soon enough (no, not immediately, but over the medium-term) steadily rising bond yields will start to soften the blow of falling bond prices, as the income from your existing bonds holdings – and the capital recycled as your short-term bonds mature – is reinvested into new bonds sporting a higher yield.

For anyone holding bonds in a fund, that will happen automatically, in time. Rebalancing your portfolio will probably help cushion the blow, too.

If you’re still a regular saver like many Monevator readers then so much the better. When bonds prices fall, you’ll be able to buy more at cheaper prices!

Remember, government bonds are anyway primarily in your portfolio as a source of relative stability and security – especially in bad economic times – not for their returns.

If you were relying on a 1.5% yield to compound to fund your retirement, then you weren’t doing it right.

Don’t do what I do

Now, I’ve been challenged a few times by readers in our comments about why I (or “we”, as Monevator) generally take this sort of line on government bonds – such as in this article on the point of bonds [9] by my co-blogger – when I freely admit I personally think government bonds are too expensive, their prices are distorted, cash offers far better returns for private investors, and accordingly I have held no traditional bonds for almost all of the past several years?

My answer is:

(a) I am a deviant active investor, remember, and…

(b) …much more importantly, if you’re a passive investor then you’re a passive investor.

I expanded my reasoning in a blog comment last month [10], arguing:

The alternative approach would have been for me (/us) to suggest passive investors do what I’ve done, and to write an article saying “time to sell all your bonds”.

But this is not passive investing, and honestly I could have written that article in 2013 and 2014, and maybe even 2012.

Overall it’s probably better I didn’t.

Why? Because bonds did their job over those years – and as a bonus they conspicuously didn’t crash.

Abandoning passive investing at the first hurdle would have been bad enough. But it wouldn’t even have worked out for you! Being supposedly smarter and more pro-active would have been the dumb move, as things transpired.

Many people, including me, started calling the bull run in bonds overdone seven years ago. (Many before that, to be honest).

Let’s quote a couple of senior bankers from Credit Suisse and BNP Paribas speaking in 2008 [11]:

“It’s a bubble as over the long term these low yields are unsustainable,” says Dominic Konstam, head of interest rate strategy at Credit Suisse.

“At some point the Fed will exit its liquidity programmes and there is no way these interest rates are sustainable.” […]

“People who lost money in stocks are now lending money to the US government for 30 years at a yield of 3.30 per cent,” says Rick Klingman, managing director at BNP Paribas.

That sounded very canny in 2008. Yet as we know, yields kept coming down for many years afterwards. And anyone who sold their government bonds in 2008 might have felt especially terrified regretful as stocks fell into the abyss in March 2009 [12].

Remember, those bankers were the experts. All they did was think and trade bonds all day. Still they got it wrong.

Why should you know better?

Or me, for that matter. For example, I wondered again on this very blog – this time in 2013 [13] – whether it was finally time for bonds to blow up.

And for a while it looked like we were on, as yields actually did march higher for six or so months.

But then, yields went back to what they’ve been doing for three decades.

Falling:

The UK bond market bull run did seem to have ended in May 2013. For a bit. [14]

The UK bond market bull run did seem to have ended in May 2013. For a bit.

Graph via Bloomberg.

Like this, over the years, betting on the top of the bubbly bond market has almost become a ‘widow maker’ trade for professionals if they were foolish enough to go into it in massive size without the mental flexibility to get back out again when it was obvious it was going against them.

At some point someone will look very smart by calling the end of the bond bull market, on the record.

(Perhaps this here post is my attempt. Take your pinches of salt!)

Nevertheless many, many people have been made to look silly for years by getting it wrong.

So I’d say beware of abandoning a carefully determined passive strategy just because it seems “obvious” bonds are overheated and the sell-off has begun.

Perhaps, but it’s looked like that many times before – and more importantly you’re either passive, or you’re not.

If you’re passive, you shouldn’t care.

Deep, man

I appreciate it feels frightening to think you’re dumbly holding on to an asset class that might be on the brink of multitrillion dollar spanking.

Surely you should sell?

But why?

What do you know that the market doesn’t know?

What do I know?

The whole reason to be a passive investor [1] is because you believe – and the evidence [15] shows – that most people know diddlysquat [16] better than the market.

Including most professionals, as demonstrated by their market-lagging returns.

And if a pervasive lack of market-beating edge is true of equities, then it is surely doubly true of the far deeper and more liquid bond market.

Bond flows make the equity market look like a car boot sale!

In that light, saying you don’t want to hold bonds because you think they look expensive is – for a passive investor – at least as silly as saying you think GlaxoSmithKline’s new drug is going to boost profits in Africa and so the shares are cheap.

Really?

Or – what’s that you say? Central Banks have obviously distorted interest rates?

Don’t you think the market doesn’t know that?

As we’ve seen above, those bonus-bagging bankers we love to hate have been preoccupied with the very low yields on bonds for nearly a decade.

All that ‘obvious’ information should be reflected in bond prices.

Foretold is not foreseen

Now, it’s very important to appreciate that none of the above means bond prices can’t or won’t crash.

Some people seem to equate the statement “the market knows best” with “prices won’t change, or be shown to be wrong in hindsight”.

What believing in a generally efficient market really means is that to all intents and purposes, all public information and all the arguments for and against every position are already reflected in prices – or at least they will be before you can profit from them.

As an analogy, let’s say you and I were both at the race track, where a red car is racing a blue car.

We are standing on the corner of the track, waiting for the cars to show themselves, and we decide to make a bet about which car will be out in front when they come around the bend.

Without getting into the mechanics of betting, the fact is one of us will be right and one of us wrong when the cars do actually show themselves – but before the cars come around the corner, there might have been equally good arguments to say blue was beating red, and vice versa.

Good arguments, one winner.

It’s the same with bonds. Yes, prices look high, but they have for years. They might crash, or we might go into deflation, or Central Banks might keep buying them up for a generation.

From a passive point of view all these ifs and buts and maybes are summed up in their price. So you may as well buy, hold, and rollover your bonds, and get on with your life.

Bottom line: If you’re a passive investor, then you’re a passive investor. Set your portfolio up according to your risk tolerance, and look forward to doing much better than most active investors over the long-term, even if every year some particular smarty pants does better over the short-term.

Nothing more for you to see here. If you like you can skip to the suggested reading at the bottom!

What’s an active investor to do?

Still here? So you think you’re an active investing smarty pants, eh?

Fair enough. Let’s toss some hot air around.

Look, I am not really sure that this is the start of the rout for bonds – but as I wrote the other day on Monevator I believe it’s probably the beginning of the end and the lows are in.

In the short-term, quantitative easing from the ECB and the Bank of Japan should continue to keep yields relatively low (and hence prices relatively high) – but that’s on a multi-year comparative view.

Given how stupendously low yields did get – such as the ridiculous negative yields on German bonds we saw back in March – it seems to me very plausible to think that rates will indeed be kept low, but not this low.

I always felt it was more likely to be the markets then the Central Bankers who dictated when rates rise. And we might be seeing that happen today (albeit talked-on by Fed Chair Yellen and co, who likely never wanted to scare us into really considering deflation.)

As I said in my article ‘It’s always calmest before the crash’ [17] back in April:

I’ve no more idea than anyone else how or when this slow death of yield ends.

But I suspect it will be with a bang, not a whimper.

The value investors at Schroders made a similar point [18] that month:

What we are seeing now are investors who have forgotten about the risk of rising rates – a significant risk in itself – and who are confusing calm markets with stable ones.

In the context of history, one might think only a Mad Hatter or a March Hare would consider negative real yields as an acceptable reward for owning government debt – and yet here we are.

Curiouser and curiouser.

Since we opined back in April, the very low yields have indeed reversed themselves. Yet if yields were to go back up to even 3%, you’d still have to squint to see the rise on a long-term chart.

Yields fell beyond that to fall to phenomenal lows by Western measures.

To me, that final dip into negative territory is looking more and more like it was a technical quirk caused by ECB buying or a last hurrah by deep-pocketed active punters such as hedge funds.

The point anyway is that yields can still stay historically low due to Central Bank measures whilst also rising sharply from those barmy lows.

It’s not a contradiction to say both can happen.

Indeed, I think that both probably is happening.

But they were our friends!

To complicate matters, the reversal of long one-way bets often cause strange dislocations to come to light in the markets.

So I suspect that years of near-zero interest rates and the coincident very low government bond yields will have wormed their way into some hitherto stable parts of the system.

For example, annoying (and often wealth threatening) as it can be to be part of an emerging consensus, I agree with commentators who argue that all the Central Bank bond-gobbling of recent years has likely made the bond market less liquid than we were used to in the past.

Add to that the partial demise of Investment Bank prop trading caused by recent regulation, and the result is likely to be more volatility in bonds than we’ve come to expect.

The sheer mathematics of very low bond yields makes volatility more likely, too.

Mario Draghi, ECB president, said as much a week ago [19]:

“We should get used to periods of higher volatility.

At very low levels of interest rates, asset prices tend to show higher volatility.

The Governing Council was unanimous in its assessment that we should look through these developments and maintain a steady monetary policy stance.”

Draghi’s warning that he’s not too bothered about volatility or the feelings of nervous investors added further to the turbulence of recent days.

In the long-term, others should step in to exploit any profitable volatility that regulation-constrained big banks are now shying away from.

Hedge funds and specialist smaller banks will do what the big boys can’t if there’s a profit in it.

But we’re not in the long-term yet. First we have to get there.

And if the volatility picks up pace, it probably won’t help matters that about 30% of the current crop of traders have never seen [20] US interest rates rise.

People young and wizened alike are perennially surprised by the speed with which an asset class can go down, after it has spent many years slowly creeping up.

I imagine the same will eventually hold true for government bonds, too.

There she blows!

So what should the takeaway be for us naughty active investors, besides be sure to have some popcorn ready to watch the drama unfold?

Obviously, you probably don’t want to be owning a lot of European government bonds at microscopic yields, unless you believe that Europe will be mired in deflation for decades.

Actually, if that sounds like you then you’ve probably already missed your chance to bail out at the price highs – the German 10-year yield is already back up at 1%, and I have a hard time seeing it going all the way down again.1 [21]

For the rest of us, beyond rate tarting your would-be fixed income money across a few decent cash deposit accounts (my choice for the past year or three) or even buying more premium bonds, it’s also worth looking out for knock-on consequences in your other holdings.

For starters, don’t expect government bond yields to soar and yet the corporate bonds or even more so the junkier high-yield bonds you may have bought into to escape unscathed.

As government bond yields inch back towards something respectable, some money should flow out of the riskier options, hitting their prices, too. Thus the impact will be felt along the curve.

Same goes for ‘bond proxy’ equities paying stable dividends (think Reckitt Benckiser, Diageo, REITs and infrastructure funds and the like).

That said, some of those have already correct to an extent, and I don’t think the over-valuation is as egregious as it was in my opinion for government bonds.

Equity investors never really, truly, bought into what ultra-low bond yields seemed to be saying. If they had then the stock market could have been justifiably on a P/E of 30 or more!

It’s also worth being alert for systemic issues if things do get really jumpy, as Matt Levine discussed last week on Bloomberg View [22]:

The biggest worries revolve around the possibility of herding among bond investors and around those investors’ funding models.

The worry is that there is one dominant model of bond investing, in which giant mutual funds and exchange-traded funds buy and hold every newly issued bond that comes along.

Those funds offer their investors the ability to withdraw money pretty much any time they want.

But if bond prices crash, investors will want to take their money out, the funds will need to sell, and all those giant bond funds that provided the bid for bonds on the way up will turn into sellers on the way down.

The growing popularity of ETFs and so-called liquid alts that can give the illusion of liquidity (through holding illiquid assets in a quoted and theoretically easily-traded vehicle) may mean this is a bigger risk than it was in the past.

One rate to rule them all

You might not think any of this matters to you if you don’t own any bonds or bond funds or ETFs or anything else bond-like.

But good luck with seeing all your equities keep their value (in the short-term, at least) if the bond market starts to gap up and down – let alone if you start to read headlines about funds being temporarily closed to redemptions and so forth.

I’m not predicting that’s going to happen (you haven’t strayed onto a doomster [23] blog) but it is a possibility given how long and strong the bond bull run has been.

Remember, all your investments can fail you [24] – and in the short term volatility can reign supreme, whatever logic dictates.

If panic breaks out, it will likely take everything with it, for a while.

Even if there isn’t some sort of panic, rising bond yields could still be bad for shares.

That’s because in theory, all assets are priced off the so-called ‘risk-free rate’, which is basically the yield on a government bond.

The excess returns you’d hope to get from shares (for taking on the risk of seeing your money clobbered hither and thither, especially in the short-term) is the ‘spread’ over this risk-free rate, also know as the equity risk premium [25].

If yields on bonds rise then either the equity risk premium has to shrink – or else shares have to sell-off to maintain the spread.

Which will happen?

Who knows!

The spread has been very wide in recent years, again indicating equity investors never believed very low bond yields were sustainable in the long-term.

When you’ve heard pundits say things like “sure, shares look expensive but compare them to bonds” to justify markets that seem high on other measures such as CAPE, that’s implicitly what they’ve been pointing to.

However, in a prolonged sell-off bonds will eventually no longer look dear, and anyway the spread will likely narrow sharply.

Quantitative easing and multi-century low interest rates have messed with the picture a bit – normally you might expect UK interest rates to be 5% at least at this point in the cycle – but that buffer won’t last forever.

To be clear I am definitely not saying shares are about to crash!

But I am saying that smugly standing by in a bond rout while patting your equity portfolio on the head like it’s a tame lapdog could come back to bite you.

Equities are far riskier than bonds in the short-run. Always.

Finally, you might try to hold more equities that could benefit if and when rates rise.

Personally I loaded up on US and UK banks a few weeks ago. Certain insurers might be another option.

Stroke play

So is this it, or Is This IT?

Time will tell, but the choppiness, the fear, the sharp moves off the extreme looking lows that some still reached to justify… when the bond bull run does end, this is surely what it will look like…

Further reading:

(Incidentally, notice the dates on those articles. They’re evergreen really, but they also indicate again for how long this question has been being asked).

  1. Remember, yields rise as bond prices fall, so confusingly sometimes us chin-scratchers will talk about a ‘crash’ in prices while other times we’ll talk about ‘yields soaring’. Both mean the same thing, but it’s usually best to talk in terms of yields with bonds, for various reasons I’ll explain another day. [ [30]]