THE membranes of global government, corporate, junk and emerging market bond bubbles are now dangerously thin.
The common view is that bond yields have risen because of expectations that the Fed will “taper” and reduce $85 billion of monthly asset purchases to a lower level. More likely, bond markets are falling and yields are rising because asset managers believe that the long bull market dating back to 1981 is over. They have decided to cut their clients’ bond holdings and have been selling bonds whenever they have rallied.
Thus while the media and TV pundits have gone on about “tapering” and the next statement from Federal Reserve Board chairman Ben Bernanke, the market has tended to go its own way. The impression of several Fed, Bank of Japan, European Central Bank (ECB) and Bank of England observers is that the monetary explosion of quantitative easing (QE) is becoming less effective; in short, the Fed and other central banks are beginning to lose control of the bond market.
For the moment bond prices are holding because overbought equity markets are slipping and investors are seeking safety. Indeed if equity bears such as economist Gary Shilling are correct, bonds may out perform equities. It is a thin line, however. The chart showing that bond yields are still close to their lowest levels in more than 200 years, illustrates that instead of safe havens, even the top quality government and corporate bonds can be risky.
Since the low point in 10-year bond yields in 2012, US Treasury yields have doubled, causing losses from the 10-year US Treasury peak of 12 per cent, that is, wiping out almost nine years of income. Thirty-year bonds which bottomed at around 2.5 percent in 2012, compared with current levels of 3.8 per cent, have slumped by 25 per cent from their top. This in itself illustrates the asset deflation dangers of the QE programme, which encouraged pension funds, other institutions and private investors to search for yield.
A McKinsey study shows that US, European, Japanese and other government bonds soared from $18 trillion in 2000 to $47 trillion by the second quarter of last year. According to some estimates, total bond holdings in the US alone, amount to some $37 trillion. Measured in constant 2011 exchange rates, the size of government, financial and corporate bonds had reached $100 trillion out of global financial assets of $225 trillion. By last year, the stock of bonds was double that of $50 trillion invested in equities, according to McKinsey.
Two key pointers indicated that these securities have become very risky for institutions and individuals. The first warning was a sudden sell-off of US Treasuries mid 2013 on the mere hint that some US Federal Reserve Board members believed that the central bank should reduce bond purchases at some unspecified time. The second warning shot was that average yields of high risk so called “junk” corporate bonds fell to a record low of 5.89 per cent, a spread at the time of only 400 basis points above US government bonds. This illustrates that some advisors, traders and investors had thrown caution to the wind and were risking money on over-borrowed, poor performing companies that could default on their debt if business conditions worsen.
Investors had become sanguine about the interest rate risk of an unexpected upward lurch in bond yields as the Fed, European Central Bank (ECB), Bank of England (BOE) and other central banks have been buying government bonds to keep both short and long term interest rates at minimal levels.
These purchases have underpinned US Treasury, German, Dutch, French and UK government bond prices in the past couple of years. The rise of bond yields- e.g. ten year US Treasury yields from a 2013 low of 1.6% to 3%, before falling back to 2.85%- show that central banks can only keep bond yields down if economies and inflation remain depressed. Despite efforts of central banks to manipulate rates downwards, market forces can drive bond yields upwards and prices to tumble.
The fear is that nervous bond investors could easily turn sellers and those who bought when US T-bond yields bottomed around 1.43% in 2012 are hurting. When bond yields rise, the price of bonds fall and the longer the life of the bond, the greater the price depreciation.
Bottom line, at current levels, US Treasuries can only maintain prices if the stock market and economy are weak in 2014. If the economy strengthens and inflation fears take hold, yields could creep upwards and prices could fall. The hope is that stock prices will not decline if bond yields rise, but that scenario is by no means certain.
Moreover, foreign investors who are wary of the Fed’s dollar devaluation policy may decide to sell, causing a further upward lurch in yields. Investors have been attracted to corporate bonds because yields, especially low quality junk securities, are higher than those of government bonds. Such has been the rush that some advisors have brushed aside the credit risk and the relative poor marketability of the issues compared to high volume blue chip shares.
Equity investor in sound companies see profits and dividends rise over the long term. The best that a corporate bond holder can hope for is a reasonable yield and the hope of price appreciation if the general level of interest rates decline.
For junk and some emerging market bonds, the prospect, following a boom in the securities in the past year and current historically low relative yields, is lose-lose, analysts warn. Rising US Treasury bond yields normally bring in their wake an increase in corporate bond yields and capital losses. On the other hand, if there is a recession, junk and emerging market bond credit risks soar and investors may attempt to sell in a thin market. Moreover, withdrawals from bond and exchange-traded funds can cause dumping of relatively illiquid bonds.
The Bank For International Settlements (BIS) has issued a stern admonition to fund managers, bankers and brokers who are advising investment in junk bonds. In a recent quarterly report, the BIS warned that “corporate bond yields fell to their lowest levels since before the 2008 financial crisis” but “appeared highly valued in a historical context relative to indicators of their riskiness.”
Examine the table below and keep in mind the following interest rate risks from buying low yielding bonds: On a bond with a 2% coupon, a 1% rise in yields leads to capital loss of 1%, on bond with 1 year to maturity, 2.9% on 3 year bond, 4.6% on 5 year bond, 6.3% on 7 year bond, 8.6% on 10 year bond, 12% on 15 year bond, 15% on 20 year bond and 19.7% on 30 year bond.
Neil Behrmann is author of Trader Jack-The Story of Jack Miner
© Neil Behrmann – all rights reserved
TEN YEAR GLOBAL GOVERNMENT BOND YIELDS
|
|
Jan 95 |
Dec 98 |
May 00 |
Nov 01 |
May 02 |
Sep 02 |
Jun 07 |
Jan 13 |
Dec 13 |
| US |
7.95 |
4.25 |
6.38 |
4.34 |
5.20 |
3.70 |
5.20 |
1.90 |
2.87 |
| Germany |
7.50 |
3.70 |
5.28 |
4.34 |
5.20 |
4.31 |
4.70 |
1.54 |
1.83 |
| UK |
8.70 |
4.30 |
5.30 |
4.51 |
5.28 |
4.39 |
5.50 |
2.12 |
2.90 |
| Japan |
4.80 |
0.84 |
1.66 |
1.31 |
1.40 |
1.30 |
1.88 |
0.83 |
0.69 |
| Canada | 8.50 | 4.68 | 6.70 | 5.02 | 5.69 |
4.81 |
5.35 |
1.94 |
2.66 |
| Australia | 10.80 | 4.90 | 6.47 | 5.15 | 6.28 |
5.33 |
6.45 |
3.44 |
4.30 |