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Watch out: how much do bond investors stand to lose?

27072016_Image2

Watch out: how much do bond investors stand to lose?

The massive losses wreaked by the Dotcom bust and the GFC could be eclipsed by the likely financial devastation when the global government bond bubble bursts. New research by Deutsche Bank quantifies the scale of the problem, and paints a particularly grim picture.

In a blog post last week, Roger quoted former bond king Bill Gross’s warning that the current global government bond bubble was “a supernova that will explode one day.” Courtesy of Deutsche Bank, we can now visualise what this historic bubble looks like.

27072016_Chart1

Source: DB Global Markets Research. Data as of 30-Jun-2016

The verdict? Not a pretty sight.

This short blog post will attempt put some numbers to the warnings. Regular readers of financial news will know that bond prices have an inverse relationship with bond yields – when yields fall, bond prices rise, and vice versa. What some readers (and seemingly many bond investors) may not know, is just how sensitive bond prices are to changes in bond yields. The table below takes the current 2 year and 30 year US, UK, Japanese and German government bond prices and yields, and calculates the impact on prices if yields were to rise by 200 bps. As can be seen in the “Loss” columns, a 2 per cent rise in yields leads to a 4 per cent correction in the price of 2 year bonds, but a massive 40 per cent decline in 30 year bonds.

27072016_Chart2

Source: Bloomberg data as at 25-Jul-2016

Take the German 30 year Bund for example. In the simplest terms, fixed income investors are essentially putting $150 into a term deposit to get back only $100 (plus some negligible interest) at the end of a 30 year term. If the interest rate (yield) moves against them in the 30 year interim, they face a paper loss of up to half or more of their initial investment depending on the magnitude of the move. Yet, somehow this hugely asymmetric downside risk appears to be lost on (or wilfully overlooked by) many investors in their scramble for the perceived safety of government bonds and higher yields further out along the yield curve.

One only needs to consider that a 1 per cent rise in yields will create a loss of up to $2 trillion for bond investors to see where this bubble is heading. The Dotcom bust resulted in $2 trillion of estimated losses, while the GFC led to an estimated $15 trillion of losses. With record low yields (and record high prices) on $37 trillion of sovereign bonds, including $15 trillion in negative yielding territory for the first time ever in recorded history, and frothy global equity markets fomented by the said low yield environment, this is a supernova that will cause unprecedented carnage to the global financial markets when it explodes.

Daniel Wu is a Research Analyst with Montgomery Global Investment Management. To invest with Montgomery domestically and globally, find out more.

Daniel Wu is a Research Analyst at Montgomery Global Investment Management. Prior to joining Montgomery in June 2016, Daniel was an analyst in the investment banking divisions of UBS and Goldman Sachs, where he covered the Infrastructure, Utilities, Technology and Media sectors.

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This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564) and may contain general financial advice that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking advice from a financial advisor if necessary.

21 Comments

  1. Daniel the one point I did not see addressed here is the impact on the banking industry. The majority of bond investors” are infact both central and comercial banks. A collapse in the bond market equals a banking crisis. Exactly as what happened in the 1931 soveriegn debt crisis, which is the main reason all those banks failed during the depression.
    The banking industry holds soveriegn bonds as their tier 1 capital reserves. A collapse in bonds undermines the whole banking industry. This is especially evident in Europe where there is no single consolidated soveriegn bond. The banks have to be impartial and hold a variety of sovereigns. This structure opens the door to a contagion if only one of the sovereigns either votes to leave the EU or is in danger of default. The question will be which bank owns what?
    Can I also point out the governments and central banks role in creating this bond bubble. They have lowered interest rates to zero and below, driving up bond prices. They have entered the bond market and bought trillions in soveriegn bonds acting as a buyer with unlimited funds. Basel 3 requirements state that the banking industry must hold more tier 1 capital reserverves (bonds). They have supported soveriegns to maintain integrity in the bond market (Greece). Around the world they have raised taxes to the point that it is causing a deflationary spiral on the worlds economy which lowers future expectations on inflation.
    This is why these acedemics that run the central banks and the lawyers that run government do not understand what they are doing. They are creating the conditions necessary to create a depression. This is the main difference between a recession and a depression. A recession like the GFC is caused when a private sector market collapses like real estate did. The soveriegn bond market collapsed in 1931 causing the great depression.
    What really ensures this crisis is the fact that these governments have borrowed excessively and when interest rates rise (bond prices fall) they are the sector most at risk, which undermines the whole banking industry. Only a fool would design a system this way. This whole bubble is being held together by the assumption that the governments will be able to sevice their AAA debts. When this assumption changes the crisis will unfold.

    • Hi Aaron, I agree wholeheartedly. But the ironic implication of all this is that capital will flee Europe en masse and push the US stock market up. That’s the only place they can go.
      Kelvin

  2. Matthew Tate
    :

    Great article Daniel, I would go further as to say the supernova won’t just hit government bond investors but spread to the corporate bond market and eventually to equity markets. Specifically the REIT sector where we have REIT’s trading 40-50% above NTA in the ‘chase’ for yield.
    We won’t know exactly when this will happen, but I would be keen to know what your trigger for a sell off in bonds will be? I am thinking it will be at the first hint of inflation from North America, the Eurozone or Japan.

  3. Maybe it will go supernova one day or one year, who knows when. But what was that old saying by Keynes that. “the market can be irrational for a lot longer than you can stay solvent”.
    And often a lot longer than people think.
    I’m better off staying at the party but not far from the exit door rather getting into a panic about future crashes. The GFC caused the market to fall by 50% but it took many months, not overnight. Likewise bond market moves will take time

  4. Johan van Wyk
    :

    Hi Daniel,

    Thanks for a very interesting article. I have a question based on it and the following quotes from your replies above:

    “We do indeed continue to invest in high quality companies trading at a discount to their intrinsic value” and “The market pricing mechanism (interest rates) has been so distorted that it is no longer a signal for pricing risk”.

    In determining the intrinsic value of businesses, how do you adjust the cost of capital/ discount rate (which normally uses a government bond yield as the risk free starting point) for the current negative interest rate environment and distorted market pricing mechanism?
    Thanks
    Johan

    • Hi Johan,
      When determining the intrinsic value of a business, we think about the discount rate not just academically in terms of WACC, but also as a hurdle rate for our investments. The latter is important because it gives us a “double” margin of safety – we only invest in businesses that trade below our assessment of intrinsic value (first margin of safety), and our assessment of intrinsic value will be conservative if the hurdle rate we use is higher than the WACC implied by the company’s funding sources in the current low rate environment (second margin of safety). If the risk free rate and cost of debt were to approach zero, the theoretical WACC would produce too low a discount rate, and taken to the extreme would create a situation where a company that substitutes debt for all existing sources of capital can achieve a valuation approaching infinity. While using a more conservative discount rate than that implied by a strict application of the WACC formula may result in us foregoing some marginal opportunities, we believe the preservation of capital is far more important than chasing potentially illusory returns by stretching our valuations and abandoning our margin of safety.

    • Lucien Heffes
      :

      Further to my earlier post, this is the specific phrase that motivated me to write my post …….”this is a supernova that will cause unprecedented carnage to the global financial markets when it explodes.”
      This is a very dramatic, highly confronting assertion and it may very well be correct. However, you can’t just make a statement like this without, as a minimum, advising readers that they should immediately seek competent financial or risk management advice.
      Surely, you are not proposing that we should ignore diversification or management risk and invest 100% of our hard earned with Montgomery to protect our investments.
      For the moment, I continue to sleep very soundly at night, but it is possible that some may not after reading this blog.

  5. Lucien Heffes
    :

    Look, I’m sorry, but blogs like this put fear and trepidation into the hearts of us mere mortals. We do not have the insight, knowledge or ability to turn on a dime if things go badly south. It’s too late by then anyway.
    All prognosticators, forecasters and analysts are eventually proven correct in their assertions and propositions, it’s just a matter of timing.
    There is no point repeatedly telling us that everything is going to hell in a hand basket unless you have the courage of your convictions and tell us:
    (a) When, roughly; and
    (b) How we should protect ourselves.
    If you need to charge for that advice, then by all means charge.
    Otherwise, it just looks (to me) like an exercise in being able to say, at some future time, “see, we told you so”.

    • Hi Lucien,
      I would respectfully disagree that all prognosticators and forecasters are eventually proven correct either in the absolute or in timing (since being early is often indistinguishable from being wrong). The global team does not attempt to predict point outcomes, nor try to time turns in macroeconomic conditions/market cycles. These are unknowable risks and we prefer to focus our time and energy on managing the knowable risks for our investors. Our investment process is probabilistic – we think in terms of likelihoods and severity rather than discrete outcomes, and try to mitigate our downside risk by investing in businesses that present asymmetrical upside opportunities. We strongly believe that the Montaka fund is a unique way to compound wealth over time with downside protection, as the ability to short unfavourable stocks in an environment of rising uncertainty is highly valuable.

      To your point about scare-mongering, that is not the point of the article. As I mentioned in a reply to a previous comment, it is important for investors to know where they stand in the cycle, even if that knowledge does not help them predict when the cycle will turn. Right now, where we stand is so far in the clouds that we can no longer see the bottom if we look back. At the very least this should be a warning for investors to conduct their affairs with greater prudence and not let greed cloud their judgement.

  6. Hi Daniel,
    I’m happy to display my ignorance if by it I learn something. Do bond yields drive bond prices or is it the other way ’round? I thought that a bond is issued with a face value & a coupon rate. When the market price of the bond goes down the yield goes up (relatively speaking) because the new purchaser of the bond buys it at a discount. The actual interest (in $ actually paid) stays the same (doesn’t it?). So if you pay less for the bond, on the open market, you get a higher yield, if you pay more for the bond you get a lower yield. So doesn’t that mean yields rise because prices drop, not the other way ’round? Doesn’t the interest remain at the coupon rate (against the face value) no matter what? So can you please explain to me what you mean when you say “a 1% rise in yields will create a loss of up to $2 trillion for bond holders”? Wouldn’t it be more accurately stated “a sudden sell off of bonds causing a $2 trillion loss for bond holders would create an increase in yield of 1% for whoever buys them”? It’s just always been a point of confusion for me.

    • Hi Andrew,
      The best way to think about bonds is that investors buy bonds based on their yield. You will often see bonds quoted on their yield (rather than their price) because yield is a measure that is comparable across all bonds. It is the % return you get if you hold the bond to maturity, regardless of how much principal you invest, the face value of the bond, the coupon rate or the tenor. Price, on the other hand, is rather meaningless for a bond – if you quote me a 20 year German Bund for $1,300, I have no idea what I am getting for my investment. That is why bonds are almost always discussed in terms of yield.

  7. Richard Vidal
    :

    Forgive my market immaturity but would this financial super nova event not lead to a massive reset on how markets are underpinned……..seems a great deal of what is occurring in world markets is not understood by anyone with any clarity these days and we continue to head down a path of unchartered financial territory…….would it not be prudent to move some holdings into Gold (regardless of the fact that for many it holds no “real” value)……I could only imagine the scramble that would ensue to protect wealth if and when this event transpires……the steady rise in the Gold Price/shares since January ’16 hints the hedging of bets is already occurring??

    • You are indeed correct in your assessment that the central bankers are charging headlong into uncharted territory full of unintended consequences. The market pricing mechanism (interest rates) has been so distorted that it is no longer a signal for pricing risk, which is why we see such a disconnect between equity valuations and economic reality. As for why we don’t hold gold, Tim has written an article on the topic posted on 28 June.

  8. Hi Daniel, thanks for the article. It does seem to be at odds with Roger’s conclusion on the blog post that you cited though. He advocated “business as usual”, ie continue to buy good quality companies at a discount to their intrinsic value despite knowing that a “supernova” was going to explode. Or have I missed something?
    Cheers.

    • Hi Mark – apologies for the confusion as the article title did not reflect the content/message of the article – this has been changed. We do not profess to know when the bond bubble may burst, nor do we try to time such an event. We do indeed continue to invest in high quality companies trading at a discount to their intrinsic value. I would also add that it is important to know where we stand in the cycle, not because it will allow us to predict when the cycle will turn, but because it can help to inform how cautious we should be.

  9. The Euro has to go. It is the one of the malignant cancers destroying world growth, not just Europe. If it’s extinguished it will be a big help to Euro nations that are performing below average and improve their bond markets.

  10. Hi Daniel

    How do the think the stock market would react to the type of event described above?

  11. Hi Daniel, thanks. Viewed from the perspective of history its unquestionable that the sovereign bond markets around the world are in a huge bubble.

    When it bursts however, what are the implications for the equities market?

    For utilities and infrastructure stocks bought for yield, they would almost certainly go down. But for high quality businesses with growth, especially large cap US stocks with those characteristics, they may well go up substantially. Funds have to park their money somewhere, and as they flee from bonds they may well bid up equities as a safe haven.
    Kelvin

  12. John Boardman
    :

    Can you provide an indication as to when we should sell all our shares and run for the hills?

  13. Does the concept of shorting bonds even exist? If so how does it stack up in terms of risk to reward ratio. IMHO the yields cannot get much more negative without heavy consequences.

    • There are inverse bond ETFs and various derivative instruments that can be used to short bonds. We do not have any special insights into the bond market, so I won’t comment on the risk/reward of bond strategies. However, it is worth keeping in mind that the oft-cited piece of wisdom “Don’t fight the Fed” applies equally to the BoJ and the ECB. These two central banks are currently buying US$180 billion in bonds every month and are expected to further increase and/or extend their asset purchase programs. The Bank of England has also committed to reactivating its QE program, if required, following the Brexit vote. While yields may or may not move further into negative territory, the volume of central bank purchases will likely keep yields suppressed in the foreseeable future.

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