By Richard Phillips, Chief Investment Officer and Kevin Muir, CFA, Market Strategist, for EastWest Investment Management, and republished here with permission
And I want to rock your gypsy soul
Just like way back in the days of old
And together we will flow into the mystic…
Too late to stop now
Van Morrison “Into the Mystic”
Although Ireland punches well above its weight when it comes to musicians, Van Morrison is a name that regularly comes out on top. According to a poll published by the BBC, the song most listened to by doctors performing surgeries was “Into the Mystic.” Tough to argue with that choice. Just a terrific tune. The song’s poignant phrase is near the end when he sings “too late to stop now…” Van Morrison must have liked it too as he named his iconic 1973 tour after the lyric.
As he traveled the globe that summer, the changes that were occurring in the financial markets were probably far from his thoughts. After decades of relatively tame inflation, the Consumer Price Index was about to take off to levels never seen during peacetime. In so doing, bond prices would be absolutely decimated. Yet this collapse in bonds would set up one of the greatest bull markets in the history of finance. During the ensuing decades, global government bond yields declined from the double-digit levels of the late 1970s to almost zero today.
But this bull market has had tremendous repercussions on the financial system. Understanding the past is crucial to predicting the future. It helps us come to terms with the fact that just as Van Morrison sang “too late to stop now,” we become addicted to debt and low rates without an answer to the question – how do we stop?
There are significant portfolio management implications from the potential end of the 35-year bull market in bond prices.
US Treasury 10-Year Yields
Setting up the greatest bull market of the past half-century
In 1962, more than a half-century ago, the US 10-year Treasury yield was trading around 4%. The CPI inflation index was running around 1% and the real yield earned by lending money to Uncle Sam was positive 3%. Investors could outpace inflation and accumulate a little wealth through traditional bond purchases.
LBJ’s “Guns and Butter” spending, which led to President Nixon taking America off the gold standard, combined with the OPEC oil embargo crisis set the stage for the great inflationary period of the late 1970s. The large cohort of young baby boomers that were just starting families threw fuel on the fire.
A few short years into the early 1970s inflation went from being under control and benign to completely unpredictable and dangerous.
The CPI inflation index spiked to 12% in late 1974 and was followed with an even bigger surge in 1980 when inflation ticked at just a shade under 15%.
Government officials attempted to get a handle on it but the vicious self-reinforcing cycle of inflation begetting more inflation had firmly entrenched itself into the psyche of the public. Bond yields spiked but not nearly high enough to compensate for the even higher inflation. Real yields (the rate of US treasury bonds minus inflation) plummeted into negative territory.
US 10-Yr Treasury Yield with Year-over-Year CPI
Then, amidst this chaos, emerged one of the most revered Central Bankers in the history of finance. Paul Volcker aggressively raised short-term interest rates, causing tremendous pain for the American economy, but in the process managed to finally tamp inflation back down.
Paul Volcker (Federal Reserve Chairman August 1979 to August 1987)
In doing so, he set the stage for the greatest bull market in financial assets the world has ever seen.
On September 30th, 1981 the US 10-year Treasury bond traded at a yield of 15.84%. Think about that for a moment. Risk-free government bonds were trading with a yield of almost 16%, and everyone was terrified yields were headed much higher. You couldn’t give bonds away. They were nicknamed certificates of confiscation.
Yet that was the day the bull market in bonds started, and they have barely looked back since.
US 10-Year Treasury Future (continuous chart)
Although inflation worries were always in the back of everyone’s mind, the reality is that from that moment on, disinflation became more of a problem than inflation. Almost every post-1980 business cycle peak saw the Fed Funds rate peak at a level lower than the previous cycle high.
Fed Funds Rate
The reasons for this change in expectations are difficult to pin down. Some liken it to Volcker’s ardent quashing of inflation. Others attribute it to a swing in demographics as the spending associated with the Baby Boomers’ lopsided population bulge progressed through its life cycle into less inflationary periods. There can also be no denying that massive technological advances had a tremendous dampening effect on inflation. Finally, in the latter half of the 20th century, as the Berlin Wall fell and the Chinese market was opened up, a tremendous supply-side labour glut caused massive pressure on wages throughout the world.
Regardless of the reason, the crucial fact is that interest rates have experienced 35 years of decline. At the same time, consumers, corporations and governments have gone on an unprecedented borrowing spree.
United States: Total Debt (All Sectors)
This is not some trickery of scale, debt has gone through the roof no matter how you measure it.
US Federal Debt as a % of GDP
The US Federal Debt is now over 100% of GDP and it’s not contained to just government.
US Non-Financial Corporate Debt as a % of GDP
Everywhere you look it’s always the same chart. Debt levels skyrocketing, interest rates plummeting.
Interest payments are low – but for how long?
Yet the sustainability of these two phenomena is specious. Given the massive decline in interest rates over the past half-century it is no surprise that the interest paid by the Federal Government to service its debt has declined.
US 5-Year Treasury Rate and Federal Interest Payments as a % of GDP
What is troubling is that during this time the total amount of debt outstanding has expanded rapidly. The low-interest payments are masking a large problem lurking beneath the surface.
US 5-Year Treasury vs. Total Federal Debt Outstanding with Interest Payments as a % of GDP
Even though interest rate payments are still ticking at low levels the total amount of debt has aggressively expanded.
This next chart is complicated but it represents an important explanation of the difficult situation the US government now faces.
US GDP YoY%, 5-Yr Treasury Rate, and Total Debt to GDP, with Difference Between GDP and 5-Yr Treasury Rate
The current duration of the U.S. Federal Government’s borrowing is a little over 5 years. This number has varied, but the US 5-year Treasury rate represents a good proxy for the cost of the Federal government’s funds. Typically, periods when the GDP has expanded more quickly than the cost of borrowing offer opportunities for the total debt to GDP to decline. Conversely, when the economy is growing at a lower rate than the cost of borrowing, it is difficult for the debt to GDP ratio to fall.
The most troubling part of recent developments is that even though the economy has grown more quickly than the treasury rate, the debt to GDP has expanded significantly. Growth is no longer able to overcome the rising debt to GDP trend.
Governments have already decided
The global economy was suffering from too much debt in 2007. The Great Financial Crisis was the result of the business cycle attempting to correct this imbalance. Debt was being destroyed (paid down), and this caused a deflationary self-reinforcing feedback loop.
At that point, governments and central bankers were faced with a choice. They could allow the business cycle to take its course and the system would reset through a deleveraging as companies and individuals defaulted on their debts, or they could push even more monetary stimulus into the system.
Of course, we know which option they chose. Unable to stomach the pain that would have accompanied a large credit-induced recession, governments and central bankers throughout the world engaged in massive quantitative easing programs. Some (like the ECB) even experimented with negative rates.
Instead of allowing the system to reset and rates to push higher in real terms, central bankers engaged in financial repression by artificially pushing rates down below the rate of inflation.
Real Fed Funds Rate (Fed Funds Rate minus CPI Inflation Level)
In doing so, they encouraged even more borrowing, and not only that, due to the private sector’s reluctance to borrow even at the new low rates, governments added fuel to the fire by leaning on fiscal policy and increasing their own spending and borrowing.
Federal Deficit (Surplus) as a % of GDP
A poor risk-reward setup
Although there are plenty of fixed income bulls who believe the 35-year bull market is intact and that long-dated government bonds offer the best protection for an investor’s portfolio, deteriorating government balance sheets should give fixed-income investors reason for pause. But more importantly, recent low interest rates create a scenario with an extremely poor risk-reward profile.
For most of this report, we have focused on American data, but the reality is that we could have used practically any developed economy. The same long-term problems are weighing on most of the world. The U.S. is simply the best choice to illustrate the challenges as they are the world’s largest economy along with the being the reserve currency to the global financial system.
For Canadian investors, it is instructive to use a local example. Canadian 30-year government bonds are yielding 2.25%. For the moment let’s assume the Bank of Canada achieves its 2% inflation target. If held to maturity, the real return on government bonds will be 0.25%. Tough to get excited about earning at most a 25 basis points in real terms for the next 30 years.
Let’s next examine what might go wrong. The current on-the-run Canadian 30-year bond is the 2 3/4% of 12/01/2048. It is priced at $111 for a yield-to-maturity of 2.252%. What happens if Canadian 30-year rates back up to the same rate as the US? A move to a 3% yield equates to a price of $95. That decline in price equates to just under 6 years of interest payments. What about 4% – a level that is by no means inconsistent with Canadian 30-year bond rates during the past few decades?
Canadian 30-Year Government Bond Rate
A move to 4% would drop the price down to $78, resulting in a capital loss of almost 30%. And a spike to 6% (a level that was commonplace in the early 2000’s) would result in a loss of more than 50%!
Investors have been lulled into believing interest rates only head one way – lower. They are most likely woefully unprepared for even the possibility of a small backup in interest rates. And, importantly, bond math makes the volatility of bond prices increase as interest rates approach zero.
The frightening possibility of a mark-to-market loss is made all the worse by the fact that investors have over-weighted fixed income since the Great Financial Crisis of 2008 in a desperate attempt to skate clear of another equity collapse.
Cumulative Flows ($bn) of Investment Grade, High-Yield, EM Debt, REITS & Dividend Funds
The chase for yield has been relentless and astounding. Investors have ventured out the risk and duration curve in a desperate attempt to pick up some return. The financial repression from the world’s central banks’ manic easing has been brutal to savers and they have responded by taking on more risk.
It seems like a perverse reaction, but even with rock-bottom interest rates, investors have been buying record amounts of government bonds. The total amount of US Treasuries held in stripped form is often viewed as a good barometer of end client demand.
US Treasuries held in Stripped Form
The outlook for bonds is poor no matter how you slice it
Bond investors are either going to suffer catastrophic losses because Central Banks lose control of the long end, or they are going to suffer sub-par real returns due to continued financial repression. Either way, owning sovereign debt at these low rates offers a poor rate of risk vs return.
Governments and central banks have already tipped their hand on their playbook. They will likely continue pushing for lower real rates in coming years. The truth of the matter is that they simply can’t afford not to. When Volcker aggressively raised rates in 1980, the Federal debt to GDP ratio was approximately 30%. Today it stands at 100%. And that’s just the US. The balance sheets of Europe, China and Japan are even more stretched.
Sovereign real yields will probably not offer attractive positive returns anytime in the foreseeable future. The Great Financial Crash was most likely the final hurrah for the bond rally and set the stage for the coming bear market (especially when measured in real terms).
US Long Term Real Yield
The cause of a potential bear market in bonds is unlikely to be aggressive rate raising by central bankers. Rather, the probable future dismal performance of sovereign bonds will be because they can’t afford to raise rates. Governments the world over will continue creating debt, leaving rates low to make that debt serviceable and even monetizing that debt by purchasing it through their Central Banks. It’s a game of hot potato with an asset that will at best yield practically nothing in real terms, with the potential of suffering a catastrophic decline if governments lose control of monetary policy. As that great bond trader Van Morrison told us, it’s “too late to stop now.”
Putting it all together: Portfolio implications
This dire scenario leaves investors stuck in a precarious position. An optimally constructed portfolio does not completely abandon yield generating assets because their forecasted future returns are low. Assets with steady cash flow play a valuable role in providing investors with the ability to weather the ups and downs from the more volatile equities portion of their portfolios.
One recourse is to attempt to enhance yield by extending duration and purchasing even longer-dated bonds. Unfortunately, given the relatively flat yield curve, the increase in yield in this scenario is marginal relative to the significantly larger risk to capital that an investor would bear.
Canadian Government Bond Yield Curve
Another option is to enhance yield by buying corporate bonds with weaker credit ratings. Again, in this environment, the risk-reward trade-off is dubious as marginal credits have been bid up to very high levels.
Bloomberg Barclays Canadian Issues +300MM – Corporate Average OAS
Given this backdrop, investors would be wise to consider another option: substituting bonds with “alternative yield” funds. These products can include investments in mortgage lending funds (retail and commercial), receivables financing funds, agricultural land rental funds, litigation financing funds, hard asset (and other collateral) lending funds, funds which lend against cash flow of mid-market corporations, private debt funds, and private real estate investment trusts. All of these have the potential for very significant yield after tax and inflation, while providing capital protection and a diversifying ballast to the equity portion of client portfolios.
Yield generating assets are still a crucial component of a well-diversified portfolio. They are simply getting harder and harder to find. Please stay tuned to our upcoming research where we will examine some of the above-noted solutions in detail.