Market Thinking

making sense of the narrative

What are Bonds for?

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The Fed cut rates again this week as expected, moving policy making even further away from economic models – as previously noted, the so called Taylor Rule that formalises all the high frequency data the bond economists obsess over would currently have rates at over 3% and rising. The US yield curve meanwhile is still inverted all the way out to 20 years and when the same economists fret that this is a signal of an imminent recession they make the same mistake, models based on historical precedent collapse in the face of a fundamental shift in policy making. Monetary policy is no longer following previous rules and nor is the bond market. Indeed, with now over $17trn in bonds globally yielding negative interest rates, the question has to be asked. What are Bonds for? In particular from an investors point of view, what is the point of the Bond Market? 

In his original book about Salomon Brothers, Liars Poker, author Michael Lewis, now better known for the Big Short, made the point that when people talk of Wall Street they think of the Equity Markets, but in reality it is all about the Bond Markets and it is about trading rather than investing. To that I would add the FX markets, the biggest markets in the world by turnover (for anything). In third place come the commodity markets, where, like FX, an enormous amount of leveraged money chases small daily price moves. These then are the noise markets as I call them, where most of the daily ‘noise’ in market commentary is generated and which investors have to learn to discriminate between the noise and the signal (to misquote Nate Silver). Both of the traditional noise markets are only tangentially connected to economic fundamentals and now it looks like the entire yield curve is now in a similar position. As such, Bonds have become tradeable prices rather than investable assets.

If Bonds are in a balanced portfolio to reduce volatility, then why not hold some other form of short dated cash instrument instead? One that doesn’t risk a capital loss. Of course part of the problem is the Rules Based system whereby regulators and governments have effectively nationalised pension and insurance company savings pools through Macro Prudential Regulation and effectively forced institutional investors to hold government bonds regardless. Indeed I recently heard of one large European Pension fund that sold its negative yielding bonds for what might seem an obvious reason, only for their regulator to tell them that they had to buy them back. 

One alternative is ‘Credit’, but here again we have Bond markets working extremely well for borrowers, but not really offering much to investors. Thanks to the ‘wisdom’ of unconventional monetary policy we have corporates in Europe where the bond yields less than the equity, even though the equity dividend is secure and other corporates in the US where the balance sheet has been geared up in order to buy back equity, which is only a benefit to existing shareholders and of course management options. Semantic tricks to call junk bonds ‘High Yield’ don’t obscure the fact that the rules based systems that let investors own BBB bonds but ban them from owning ‘High Yield’ exist for a reason. Market Thinking is all about observing herd behaviour and if you want to see a Herd in action, just watch the behaviour of investors when the BBB bond downgrades happen.

This is important as there are now over $3trn of BBB US corporate debt being held, 10 years ago they were a third of the investment grade market, now they are over half. Last week, Moody’s downgraded Ford to ‘junk’ affecting its entire $84bn of debt and a recent report from them suggested that another 47 companies are similarly vulnerable.

For unconstrained investors the question has to be when, rather than if they sell their bonds and replace them with something, anything. However, the idea of switching to Credit, or even some of the (highly leveraged) bond proxy equities looks equally questionable. Bond investors have ridden a perfect storm of capital gain such that the role of equities for growth and Bonds for yield has been completely inverted. Rather than being a (measure of) risk free return they are now return free risk. Both Bond traders and Bond Investors are facing an existential crisis, what to do now?

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