Bond Bubble - Why Now?

The yield on many government bonds has turned negative and that has led some people to suggest that we're in a bond bubble.

Prices are just simply too high because they have been over inflated by central banks pumping money into the economy.

If they are too high then perhaps they are about to crash so in this blog we will look at how big a crash in the bond market could be and where we should expect rates to be over the long term.

In a spreadsheet from Charlie Bilello below you can see the negative bond yields in pink.

Over time the amount of debt which has negative yield is increasing so that in June 2019 it reached 12.5 trillion dollars

Why Buy Bonds?

There are 3 main reasons for buying bond these are:

• Capital Protection
• Diversification
• Income

Capital Protection

We buy bonds for capital protection and in the case of government bonds from developed markets they are very safe.

In the graph below we compare the return on the S&P 500 with the return from 10 year treasuries since the 1950’s. 

You can see for equity (in red) there are lots of rises and falls in the price and that's because equity is very volatile.

If we compare that with bonds (in blue) you see a much smoother line. There is still up and down movements relative to the trend but these tend to be much smaller.

As an investor you may want to think about how much the index has fallen relative to the highest peak it's reached. If the index is at an all-time peak then it stays at zero but if we fall relative to that peak we start to see a drawdown. 

What really stands out for equity (below in red) is that those falls relative to the peak are very severe. For U.S. stocks there are several times when it's been more than 40%,  in the 1970s, in the early 2000s and during the global financial crisis.

If we compare that with bonds (in blue) you can see the crash is much smaller relative to the previous peak. It's very unusual for it to be more than 10%.

So while bond bubbles for U.S. treasuries have popped in the past, the size and duration of those bond bubbles bursting are considerably smaller than they are for U.S. equities. Therefore there is a lot less to fear about the popping of a government bond bubble than there is for an equity bubble.

Below I look at that difference between bonds and equity in a slightly different way. The monthly return is on the x-axis, so positive returns are on the right and negative returns on the left.

You can see that this downside tail for equity is much bigger than it is for bonds. It is very unusual for bonds to stray below around -5%. For equity there have been several cases where a monthly returns have been less than -5%. 

So bonds preserve this cardinal rule of investment which is not to lose money or at least not too much and not for too long.

Diversification

Another reason for holding government bonds is diversification.

Below are some Vanguard funds and the size of the dots on this diagram show you the size of the correlation between two funds.

For example you can see by the size of the dots that the European Equity (VEUR) is highly correlated with a UK FTSE 250 index (VMID). Whereas the correlation between European Treasuries (VETY) and the FTSE 250 is very low.

This block of very large dots shows how equity funds are highly correlated with one another.

It is  almost impossible to diversify the equity in your portfolio by buying another equity fund. No matter where that equity fund is based or its investment style.

This is also true,  to a lesser extent, with bond funds, they are also correlated with one another.

The place you get diversification is if you combine stocks and bonds. Only then can you really reduce the overall volatility or risk of your portfolio. 

Below we just consider two funds: a FTSE 100 fund and a UK Government Bond fund, in the period between December 2016 and June 2019. Risk is plotted on the x-axis and return on the y-axis.

You can see that the stocks are high risk and high return, whereas the UK Government Bond is low risk and low return.

These bonds have have about half the volatility of UK equity but if we combine them in this magic ratio of 75% bonds and 25% shares, the portfolio has a risk which is smaller than either government bonds or UK equity!

Therefore, although it's return is considerably less than for stocks, that minimum risk portfolio has a return which is considerably better than that of UK government bonds alone. 

This is  what we mean by diversification. We combine assets and the combined risk is considerably less than the risk of any of the ingredients.

Income

Another reason for choosing government bonds is to generate income for your portfolio.

Does Negative Yield = Negative Income?

Many people ask me, if the yield is negative does that mean the income from their bonds will be negative.

Take for example an iShares fund which buys UK gilts (e.g. UK government bonds). 

Below you can see the fund paying out twice a year since November 2015 and the payments are always positive.

Dividends on a fund will only ever be zero or positive, they can never be negative.

A government bond starts off its life at a price of £100 and it ends its life at £100. This is because all you are doing is lending that money to the government and then receiving your £100 back after a set period of time.

In the interim you will receive some interest payments and that's the coupon. 

The bond below was issued in 2013 and paid a coupon of 1.75%. Notice how the price started out at around £100, it rose a bit and then it fell back to £100 just before it matured in 2019.

So if we invest a £100 in the bond we would be paid twice a year, which is the convention for UK government bonds, and each payment would be half of that 1.75% which is 87.5p.

The last coupon payment would be on the 22nd of July 2018 and this coupon will never be negative.

A coupon can be zero but it will never, ever be negative.

Below is an example of a bond which will give you a 0% coupon. In other words no interest payments at all.

This is a 10 year bond which was issued on the 10th of July 2019 and it will mature in 2029.

You can see the coupon is 0% but note that even though the yield is negative the coupon isn't negative.

If  we can take the total return on a bond and break it down into two components it looks like this.

Total Return = Capital Gain + Income

Capital gain is when you buy at a low price and then sell before maturity at a higher one. Income is the coupon payments.

The fund below is an iShares UK Gilts All Stock Index Fund which purchases UK Government bonds. 

I have compared the accumulation version of the fund (e.g. where the price incorporates the coupon payments) with the income version (e.g. where the price doesn't reflect the income). 

If we subtract one from the other we can see the income from the fund and separate it out from the capital gain.

Below are those two components, the capital gain is in red and the coupon income is in green.

Notice how that coupon income is like a steady, safe heartbeat. It is effectively riskless because it's paid to you by the UK Government which has never defaulted on its debt and it has never failed to pay a coupon.

Compare that with a capital gain which is extremely volatile and risky. This is because it responds to the changes in the yield curve which is flopping around all the time.

Below I have put those two components onto a risk return plot.

You can see that the capital gain has been very high but it's also been very risky.

The coupon income for UK Gilts is extremely safe, almost risk-free, but of course it's much smaller than the capital gain that we have seen as yields fell.

Can Capital Gain be Negative?

The eurozone yield curve has a -0.38% yield but what does that mean in terms of individual German bonds?

Below is a 10 year bond that matures in 2029. At the time it was issued in January 2019 a fair coupon was considered to be 0.25% and that will be fixed for the entire lifetime of the bond.

We saw for the gilt the value of the bond on the day that it was issued was a 100 euros. Then its price steadily increased until it reached a 106.3 euros on the 5th July. However you need to remember at maturity the bond will always go back to its original value of a 100 euros. 

Because the bond will exist for 10 years, it means that we are going to lose out on 6 euros spread over 10 years, which is a capital loss of 0.6%.

That means that the total return on the bond will be the income which is 0.25% minus the capital loss which is 0.6%, which will give us a total return of -0.35%.  

As the price of the bond went up the yield on the bond went down until it reached -0.37% in July. It's not because the income was negative, it's because the capital gain was negative and that dragged the total return into negative territory.

Can Total Returns Be Negative as Yields Increase?

Now the natural fear when yields are negative is to worry about what will happen if yields suddenly start to increase, which in turn could make the price of bonds fall sharply.

Could we still get a positive return even if yields are increasing? 

As it turns out yes we could, and in order for this to happen the income would have to exceed the capital loss in any period of time. 

The income is just the % coupon and that is fixed. In order for the total return to be positive, this has to be greater than the capital loss. The capital loss for a bond is its duration multiplied by the shift in the yield curve. 

This is why we say the longer the duration of a bond the greater its risk. Therefore a 30 year bond is much riskier than a 10 year bond.

If we divide  by duration on both sides of that inequality we come up with this very simple result.

You can think of this as a speed limit. If the yield change is slower than the speed limit over the course of a year, then even though yields are increasing, we could still make a positive total return. 

The speed limit is defined by the coupon of the bond divided by its duration

In the case of the German bond I discussed earlier the coupon was 0.25% and the duration was 9.5 years, which means that the speed limit is 0.03% per year. 

If the yield curve increases by more than 0.03% per year we'll make a loss on the bond.

For that bond which had no coupon at all the speed limit is zero. So any increase in the yield will decrease the value of the bond.

Can We Apply the Same Logic to Bond Funds?

Can we apply this speed limit idea to bond funds? Yes we can!

Below you will see the ishares Gilt fund IGLT as an example. 

The yield of the fund is 1.2% as of the 4th July 2019. The effective duration was about 11.6 years and that means the speed limit is 0.1% per year.

If the UK yield curve increases at more than 0.1% per year then we would make a negative total return on this fund.

Below is a graph of the value of a hypothetical £10,000 invested in that fund since December 2006. 

Over that period of time you can see the total return has been positive. But also for the same period yields have been falling in the UK, therefore both the income and the capital gain have been positive.

How Much Will Rates Rise?

A key question is how much rates are going to rise? They are at an all-time low at the moment but if rates don't rise much from where we are now then that could limit our capital loss.

Below is the UK 10 year rate since 1993.

You can see that is has been falling fairly steadily over that entire period. That has been great for bond holders because they made capital gains during that period.

Fortunately the Bank of England keeps very long term records and you can see that their Bank Rates below has been falling fairly steadily since the early 1980s.

In fact the Bank of England’s records go all the way back to 1694 and the  average rate has been somewhere around 5% over that huge period of time. 

There was a large spike in the 1970s when inflation reached very high levels. After the financial crisis there has been another very unusual period but in this case it is because rates were very low. This has been the case for many central banks around the world.

The Bank of England uses the term equilibrium interest rate also known as R*. 

Think of this as a kind of anchor rate to which policy returns if everything is okay. By okay we mean a position with no output gap, where our economic output is equal to our potential output and inflation is at the 2% target rate.

If the Bank of England sets the bank rate equal to that R* value it will  just keep the economic machine ticking along. 

If we look at the Bank of England inflation report from August 2018, they do a fascinating analysis which shows that the bank rate is likely to remain materially below that 5% level the we have seen since 1694. 

The estimated fall in the equilibrium interest rate R* It is not just a small fall, it is more than 2% since 1990.

If we add back inflation at 2% that means that neutral rate or R* will be around 2% to 3% which is considerably lower than 5%.

You can see that the equilibrium real rate was falling before the financial crisis. It fell significantly during the crisis and now it  has come back to a level which is far lower than it was in the past.

What are the economic drivers of that fall?

The big ones are slower population growth, increased life expectancy and very slow productivity growth here in the UK.

None of these things are likely to change much in the near future, so that lower R* value is likely to be here for some period of time.

Our population continues to age and our productivity growth remains stubbornly low. As the Bank of England raises rates,the upshot of this for bond investors will be that the endpoint will be much lower than it was in the past.

This means that those capital losses will be smaller than you might expect if the equilibrium rate was still at 5% and this will limit the size of the pop if the Bond Bubble bursts

The capital gain on bonds has been boosted by that steady fall in yields that we've seen for several decades, but that is about to end.

However it looks as if we are not going to see a huge spike in rates, given the beliefs about R* which is now going to be lower than it was in the past.

Therefore I am not particularly worried about a Bond Bubble and I certainly wouldn't buy into the idea that you should have no bonds in your portfolio because the bubble is about to burst.

Michael Burry, who successfully predicted the Dot Com Bubble and US Housing Bubble, says we are currently in an Index Bubble. If you would like to read my blog about this then please click (here)