06:53

Why are bond yields so low?

An interesting article by Louis Gave of Gavkal on why interest rates are so low and likely to stay that way for longer than most think.

As long as men continue to age, they will probably complain that “things were better in their day” and that “the world is going to hell in a hand-basket”. Ignore for a moment that the proportion of undernourished people fell from 23% of the developing world in 1990-92 to under 15% in 2010-2012, that more than two billion people gained access to improved sources of drinking water in the past decade, and that never in history have so many people across the globe lived so comfortably—as far as financial markets are concerned, the ‘old-timers’ may have a point.

Indeed, anyone who started their financial career in the late 1990s has had to deal with the Asian Crisis, the Russian default and Long Term Capital Management failure, the Technology, Media, Telecom (TMT) bubble and collapse, the subprime bust and global financial crisis, the eurozone crisis and the past 12 months’ bond market taper tantrum and emerging market wobbles. In other words, there have been plenty of opportunities to catch the volatility on the wrong side. And these recurrent punches in the gut (combined with the recent violent rotation from growth stocks to value stocks or the fall in the renminbi), may explain why so many investors continue to seek the shelter of the long-dated treasuries, bunds and Japanese Government Bonds, despite these instruments’ apparent lack of value. Simply put, after almost two decades of repeated financial crises, investors todayĆ¢¨do not have their forebears’ tolerance for pain. And so the old timers may be right: today’s young people are wimps, for both theoretical and practical reasons:

• An inherent level of systemic risk? Most people intuitively feel Karl Popper’s observation that: “In an economic system, if the goal of the authorities is to reduce some particular risks, then the sum of all these suppressed risks will reappear one day through a massive increase in the systemic risk and this will happen because the future is unknowable”. In other words, suppress risk somewhere and it comes back with a vengeance to bite you on the derriere at some later date. Look at 2008 as an example: we cut up credit-issuing risk into tiny parcels and distributed it across the system through securitization, only to see the banks take on a lot more leverage and ultimately sink their balance sheets on instruments they failed to understand. Hyman Minsky summed up this inherent contradiction well when he stated that “stability breeds instability”. In other words, the more stable a thing is, the temptation rises to pile on leverage, which makes that “something” more unstable on the back end.

• The notion of Anti-Fragile: the above brings us to the Nassim Taleb notion of “anti-fragile”: just as a parent who overly cocoons a child prepares that offspring poorly to function in the wider world, so policy-makers intent on cushioning the private sector from every shock in the economic cycle are doing the overall system a massive disservice. By preventing the build-up of immunity, or the ability to thrive in crises (i.e., anti-fragility), policymakers sow the seed for a greater crisis down the road (hence the repeated cycle of crises).

• Lay the blame on zero interest-rate policy (ZIRP): following on the above, not only does ZIRP allow the survival of zombie companies (which drags down the returns for everyone) but it most certainly affects investors’ behavior. Firstly, by encouraging banks to play the yield curve and buy long bonds, rather than go out and lend. Secondly, because almost all investors hold part of their assets in equities and part in cash or fixed incomes. And in a world in which fixed income instruments yield close to nothing, the tolerance for pain in other asset classes probably diminishes all the more. Indeed, if an investor is guaranteed a 7% coupon on his fixed income portfolio, then a mild sell-off in equity markets can be easily dismissed. But drop the yield on the bond portfolio to 2.5% and all of a sudden, the slightest drop in equity markets risks pushing the overall returns of the total portfolio into the red... Unless, of course, one holds much more fixed inc ome instruments than equities. Paradoxically, that growing population cohort which seeks a guaranteed level of annual income faces the perverse reality that low bond yields force an even greater allocation of their savings into bonds! And this quandary is further amplified by the last point.

• The changing structure of savings: a generation ago, employees of large corporations would typically be enrolled in that company’s “defined benefits” pension plan. This meant that most salary-men, at least in the US, could look forward to a fixed monthly sum upon retirement, regardless of a) how long they lived for and b) what the market did. At that time, the overall behavior of financial markets was the concern of the pension fund’s managers who, if they were wise, could average up in bear markets and take some gains off the table when markets got hot; in other words, stomach the volatility of financial markets (back-stopped by their companies’ long-term earning power) for the long-term benefit of their plan holders. But today, following the evolution of most pension plans away from “defined benefits” to “defined contribution”, the average pensioner’s relationship to his pension has been turned on i ts head. Today, the average saver receives a monthly statement explaining how much he has saved; and any dip in that amount triggers sentiments of panic and fears that a looming retirement may not be well provided for. Combine that fear with rises in healthcare and college costs (two costs that older folks have to worry about) that, over the past decade, have typically continued to outstrip inflation and any dip in the market is more likely to trigger a sentiment of panic, and rapid shift into bonds, than a willingness to ‘buy on the dip’.

Putting it all together, it seems hard to find one factor that explains the low level of yields. In our view, the ageing of our societies, ZIRP and the low level of rates, the shift from defined benefits to defined contributions, the activism of policy-makers (who, by attempting to cushion the volatility of the economic cycle more often than not end up increasing the volatility of financial markets down the road)... have all had a hand in keeping interest rates low. And if that is the case, then it will probably take a marked change in some of the above factors to trigger a significant rise in bond yields?

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