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A Broken Bond - Outside View by Nitin Gregory

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A Broken Bond
Aug 30, 2016

  • Global yields lowest in 500 years of recorded history. $10 trillion of neg. rate bonds. This is a supernova that will explode one day. - Bill Gross

The bond markets in the developed world are a concern. Reputed investors like Paul Singer and Bill Gross say the market isn't functioning as expected.

Now, the bond market in developed countries draws large amounts of capital. By some estimates, the US bond market is US$30 trillion! Large investors, pension funds, and corporates use the bond market to park money and generate regular income. Government bonds in particular are sought after for their safety.

A bond primer

Bonds are nothing but loans to governments or companies. The price and yield of a bond have an inverse relationship. If the price goes up, the yield goes down. Today most bonds are at historically low yields. This is primarily because of central bank bond-buying programs known as quantitative easing.

Interest rates in the US are lower than any other time in history. In fact, some countries have a negative interest rate - they are charging savers! By some estimates, around US$13 trillion worth of bonds have negative yields. The yield on ten-year treasuries is lower than the dividend yield on the S&P 500. This has to have negative consequences.

What did they expect?

So low bond yields can be attributed to the monetary policies of central banks around the world. After the Great Financial Crisis of 2008, monetary policy is kept loose to help cushion the economy. They were hoping for an uptick in investment and possibly benign inflation. The hope is that the low-rate scenario will incentivise corporates to increase capital investment.

Interest rates are the hurdle rate for investors - i.e. the return expected for delaying consumption. Investments that do not meet this rate are value-destroying and get culled with time. But the low-rate environment has clouded the culling mechanism. It has resulted in a phenomenon called 'zombie companies'. Many businesses with returns lower than the cost of capital are able to survive in this easy funding scenario.

What has actually happened?

The indicators of business investment (capital expenditures, for example) have been lackluster. Growth was low in 2015 and even went negative in the beginning of 2016. Many companies have resorted to stock buybacks. Indeed, inflation seems to be missing in action.

The clouded 'culling' mechanism means there are dangers lurking in the investment universe. An investor will have difficulties measuring the quality of the business. Demand and supply dynamics are also difficult to estimate.

Say an investor wants to invest in a coffee company. The coffee company is generating a stream of cash flows, but what would be the right discount rate to value this business? Now, a few zombie companies in the area might go bankrupt in the future. Does that mean future consumer demand is set to fall because of reduced employment and demand? Will more competition arise in the vicinity given the cheap borrowing scenario?

Low yields have also affected public and private pensions. The pension schemes have a large share invested in bonds to generate an annual income for retirees. But low yields mean that an even larger amount has to be invested to generate the same annuity. Alternately, you have to take higher risks in other asset classes in the hope of higher returns. It is estimated that the total pension deficit in the US is greater than US$3 trillion.

The current scenario of low investment, low interest rates, and sluggish growth has drawn comparisons with Japan. Not allowing free-market forces to decide the allocation of capital could mean an extended period of Japan-style stagnation.

This column is authored by Nitin Gregory. Nitin, who graduated from IIM-Calcutta, is currently pursuing a finance role with an automotive major. He has a deep interest in Macroeconomics and pens a blog at Gregonomics.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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