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Response to Roger Montgomery on bonds

In a recent article in Cuffelinks, Roger Montgomery asked the question, “Are bonds failing us as a warning signal?” He argued they are, for two reasons. First, bond yields are “an artifice created by central bank buying” and thus do not reflect economic fundamentals. Second, credit quality is low and yet corporate bond yields are also low, which means the market is signalling incorrectly about risk in the corporate sector.

This article debates both those aspects of Roger’s argument.

Let it be said at the outset, however, that the debate is not about whether bond yields are unusually low. Of that there is absolutely no doubt. Across the credit spectrum – from high quality government bonds through investment grade and high yield corporate bonds – yields are at absolute historically low levels. A large chunk of the world’s government bond market (all in Europe and Japan) is trading at negative nominal yields, and the average yield across the US Treasury market is only 1.1% (which incidentally is not the lowest ever – that mark was posted four years ago when the average US government bond rate was just 0.8%, although at the longer end, 10 year bonds at 1.5% match the low they reached in 2012.).

More to low rates than central bank buying

We need to analyse the drivers of the bond markets more rigorously before we conclude that the only reason for the low yields is central bank buying pushing against fundamentals, which are ‘sending the wrong signals’.

Central banks have been buyers – in Europe and Japan this continues, though the Fed stopped a couple of years back - but so have many other bond market participants. At the peak of the Fed’s buying, there were plenty of Treasury bonds being supplied, with the US budget deficit running at 10% of GDP. However, the deficit is much lower now, back to around 2.5-3.0% of GDP. Continued buying of US government debt issues has taken the average bond yield on US Treasuries from around 1.5% two years ago to 1.1% now, but this has been demand from the market, not the Fed. There is no longer a ‘central bank distortion’ in US Treasuries.

It’s just as valid to see negative and low bond yields as the result of a poor macroeconomic environment. Rather than monetary policy ‘not working’, the economic headwinds have been so great that all it’s prevented is an even worse outcome for growth and unemployment.  A real rate of return on risk free capital (i.e. government funds) in this climate is non-existent. The real yield on 10 year US inflation-linked bonds is just 0.1%.

Low inflation, with widespread forecasts of deflation, therefore argue that current bond yields align with the fundamental drivers of bond markets in a fairly normal sort of way. Far from sending a failed signal or being dysfunctional, the bond market is performing as expected.

Roger’s article also suggests that corporate bonds are not expressing risk levels appropriately.  However, the spreads over US Treasuries (the credit risk premium) that corporate bonds are paying, across the range from AAA to CCC, are close to long run average levels. Not wildly tight, as would be needed to support a claim that risk isn’t being priced properly.  Arguably, that was the case before the recession in the US in 2000-01 and before the GFC, which both saw spreads trading at close to 1.5 standard deviations below average. At those times the market wasn’t paying credit investors enough for the macro risk that was evolving.

However, in 2016 this is not the case. When US growth is chugging along, not great and struggling to sustain any acceleration, but not slumping in a way that causes huge concerns about corporate defaults, spreads are at around their long run average.

Low corporate rates driven by low government rates

The only reason corporate and high yield bond yields are at absolute low levels is because the underlying government rate is low. The extra yield over that rate to compensate for credit risk is still providing adequate compensation for risk.

Let me give just one ratings band to illustrate. BB-rated bonds in the US are currently trading at an average yield of 5.07%. This is a spread to US Treasury of 3.9%, spot on the long-run average spread to Treasury. They were even tighter in early 2014, at 3% even.

Pre-GFC, BB spreads were below 2%. That level was crazy because the break-even spread for BB is 2.15%. That is, at a spread of 2.15%, BB credits are paying just enough to cover the expected loss from defaults in that part of the market. In the current market, investors are being paid well above the break-even.

The article also says corporate debt issuance has been excessive. Maybe in China, as the chart in the article shows, but not in the US. In the investment grade space, the size of the market has been growing at 9.7% per annum for a couple of decades, the same in the last two and five years.  In the high yield space, the market has been growing at a slower pace over recent than its long run expansion. In the lowest-rated credits (BB and CCC), there has been little expansion for the past few years.

Uncommon and common ground

The bond market faces issues, especially for those who trade in it and require lots of liquidity to move large parcels of securities around quickly. But as a fundamental signal of how the fundamentals of the world economy are tracking, it is still providing valuable information. That’s a different view to the one that Roger presented.

What I share with Roger is the desire to see a world that provides investors across all asset classes with stronger returns. But I don’t blame central banks for the fact that this isn’t the case – they are merely players in the same very difficult game as the rest of us.

Comment in response from Roger Montgomery

"I have absolutely no problem with this alternate view. I don’t agree with the general proposition that this is normal and there’s nothing really to see here. Yields on US 10-year treasury bonds are lower today than they were during the Great Depression, indeed they are the lowest they have ever been since the 1700s. I suspect that is not a reflection of the state of the economy and if it is, we are in a whole lot more trouble. Different views are what makes a market and if others want to buy the securities I am selling, I’d be lost without such views."

 

Warren Bird is Executive Director of Uniting Financial Services, a division of the Uniting Church (NSW & ACT). He has 30 years’ experience in fixed income investing. He also serves as an Independent Member of the GESB Investment Committee. 

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3 Comments

Warren Bird

August 11, 2016

Just to clarify, I didn't say current rates are 'normal'. I don't find that a helpful terminology. My opening comment about rates being 'unusually low' was meant to convey this thought.

I saw a fantastic chart this week showing government interest rates back to 3000 BC. For about 4,900 years both short and long rates were basically in the 3-5% range. But in the 20th century they've mostly been either lower (1930's, 2008 until now) or higher (1920's, 1970-2000). We haven't seen a consistent period of "normal" for a hundred years! I'd love it if Roger is right and we get there sooner rather than later.

Jonathan Rochford

August 11, 2016

Global GDP growth is well below long run averages and the US is only limping along this year with GDP growth running at around 1%. Europe and Japan have been struggling to grow for years with both having excessive debt levels. China is the only major economy growing strongly but that growth is based on debt growing much faster than GDP, which is typically called a Ponzi scheme. The global economy is clearly in poor health.

Central banks have pushed down bond yields with quantitative easing and low or negative interest rates. It's a global race to the bottom with everyone hoping that lower rates in their jurisdiction will push their currency down and provide an export boom. That hasn't worked for anyone.

The GMO long range forecasts for asset class returns are cause for everyone to reconsider their return targets. Arguably the only asset class offering decent yield, without high risk and betting on interest rates going lower is private debt. Australians are fortunate that the market for private debt is uncompetitive offering the ability to outperform equities whilst taking much lower risk.

Roger Montgomery

August 11, 2016

I have absolutely no problem with this alternate view. I don’t agree with the general proposition that this is normal and there’s nothing really to see here. Yields on US 10-year treasury bonds are lower today than they were during the Great Depression, indeed they are the lowest they have ever been since the 1700s. I suspect that is not a reflection of the state of the economy and if it is, we are in a whole lot more trouble. Different views are what makes a market and if others want to buy the securities I am selling, I’d be lost without such views.


 

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