Hidden Risks

Last night, we had dinner with neighbors … “Bad luck is sometimes good luck,” said one. “My grandfather invested his fortune in Russian bonds. This was before the Russian Revolution. At the time, he was told he couldn’t lose money. Because the bonds were pegged to gold. So there was no currency risk. And these were bonds of Russian railways, which were the most solid businesses in the world, and they were guaranteed by the tsarist government. No currency risk. No default risk. No business risk. They were as close to risk-free as you can get. But when the Bolsheviks took over they seized the railways. They stopped paying the bonds. And they executed the tsar and his family."

It didn’t make any difference if the bonds were pegged to gold or not. They were worthless. It just reminds you of how things can go very bad in a way you don’t expect. Who would have imagined a communist revolution in Russia? Communist revolutions were supposed to happen in developed countries. They were supposed to be led by the urban proletariat – by factory workers. Russia was the last place you would have expected such a thing. But this experience did have one positive benefit. Our family has been inoculated against bonds ever since. We haven’t bought any for 100 years.

 

“Well, you lost money for the last 32 years,” we replied cheerfully.

“But I don’t think we’ll lose for the next 32,” said our friend.

“It’s hard to make predictions, especially about the future,” as Yogi Berra put it.

Maybe there’s another version of the Russian Revolution coming – a big event that is totally unexpected. And maybe it will wipe us all out. Who knows? So we will confine our predictions to the past, where we’re on more solid ground.

 

Of Bats and Bonds

What we notice about the past is that bond yields are cyclical. And crises in the bond market are episodic. And now we can tell you why. We just figured it out, thanks to a visit from our friend Dylan Grice, former chief strategist at French investment bank SocGen. Dylan explained that vampire bats share blood (their food) with one another. This helps the colony survive periods of food shortage. But as the colony flourishes, individual bats have less incentive to share. Each bat gains nothing from sharing his food with others if (1) other bats will give up their food (assuring the survival of the colony) and (2) they will give it to him when he needs it. In other words, the more the bats cooperate with one another, the less a single bat gains from cooperating.

Quick-witted dear readers will see parallels in the bond market. When you lend money (buying a bond, for example), you have to trust the person you lend to. As your level of trust goes up, you accept lower interest rates, because your risk of loss goes down. This is equivalent to the cooperation in a bat colony. As interest rates decline, borrowers go deeper into debt. But as the quantity of debt increases, the quality decreases. Or, to put it another way, as cooperation and trust go up (with falling bond yields), the foundation under bond values (the ability of the borrower to repay his debt) goes down. Eventually, you necessarily reach a point where the trend must reverse – where trust declines and bond yields go up.

 

Woe to the Debtor

Are you still with us? Hope so, because this is important. It’s why bond yields are never stable. As far as we can tell, we are the only candidate for the top Fed job who seems to understand the cyclical nature of the bond market. The others appear to think they can jimmy up bond prices forever. But as we have seen, it ain’t possible. The higher bond prices go (or the lower bond yields go) the more the trustworthiness of the participants is undermined. Markets go up and down, correcting mistakes in both directions. Bonds trade in a market. Ergo, bond yields will go up and down. As long as bond yields are going down, borrowers can afford to borrow more. But when they go up… woe to the debtor. He won’t be able to repay his debt.

Then woe to the lender; he won’t get his money back. And woe to the central banker who tries to stand in the way of the market. And woe to the investor who buys bonds and fails to see all this woe coming his way. And woe to the holders of US bonds. At this point in history, Russian railway bond certificates – as collectors’ items – would probably be a better place to put your money.

 


 

 

 

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3 Responses to “What Vampire Bats Can Tell You About Bond Yields”

  • Solon:

    By the way, my guess at when the bond market bribe ends–as I don’t believe it can be carried on indefinitely on a practical basis–is when the volatility in price is greater than the capital gain offered by the Fed in the secondary market. When speculators can be completely wiped out in the short term, they won’t risk doubling their money over the longer term… and then they will be forced to look towards gold for the preservation of their capital as the sovereign GB markets, and thus their currencies, would be irrevocably destabilized.

    Part of the Fed’s move to absorb so much of the secondary market is to keep a check on bond price volatility (is my guess). They must fear that the market has been close to that point where their bribe has become too risky.

  • Solon:

    Mr. Bonner,

    I don’t find your article very clear. What period do these cycles to which you allude have? To which duration do you speak?

    I pull a chart of bond yields from 1980 to 2013 and I see yields going in only one direction.

    Not to mention yields are somewhat controlled by a Central Bank (and accounting rules, and banking legislation, etc etc)… the free market phenomenom you seem to describe and for which you offer an analogy is stifled, if not non-existent.

    Professor Fekete teaches us that capital gains on bonds achieved by front-running the Central Bank are a bribe to the bond market to continue to keep the fiat ponzi going (I will reference the source even if The Wiener above won’t). These capital gains can be offered somewhat indefinitely as yields can theoretically halve indefinitely. It was bond speculators during the Great Depression that made the most money, again front-running the Fed.

    Not to mention the market is now global and bond yields are often dictated by a flight or rotation from one sovereign to the next. I think it is pretty obvious that the USA has the deepest and most liquid bond market on the planet despite its debt overhang. It is the cleanest dirty shirt. Don’t you think it more likely that the cracks will start to appear in the periphery markets first? If not, why not?

    I see nothing in your article which addresses these phenomena… the actual nature of the sovereign bond market we are immersed in today.

    Fekete’s point, the one The Wiener doesn’t source above is that by the *artifically* lowering interest rates, the Fed is actually damaging the area of the economy that it believes it is trying to help… it is pushing on a rope and thus causing unseen capital destruction despite its attempts to flood the market with cheap credit. This policy is deflationary in its nature despite its attempts at generating inflation.

    We have seen this same deflation in Japan occur despite several monetary printing exercises and an ungodly debt-to-GDP ratio. It has been occuring in the USA for the past 5 years despite the Fed’s massive attempts at reflating.

    Here is a link to one of the shorter Fekete articles regarding the bond market:

    http://www.professorfekete.com/articles/AEFNoBusinessLikeBondBusinessStill.pdf

  • Keith Weiner:

    In rising interest rates, I think one must separately deal with the cases:
    1) Rates rise and one must borrow subsequent to the rise (e.g. rolling short-term liabilities that fund long-term assets)
    2) One has borrowed previously, at lower rates, and now the rate rises.

    I agree, clearly those who must borrow will find they cannot afford it when the rate rises past a threshold. But for those who have already borrowed, a rising rate eases the burden of debt (as a falling rate increases it).

    Think of the Net Present Value of a stream of payments. Each future payment is discounted based on an interest rate. If the interest rate is zero, and if the duration is perpetual, then the NPV is infinite.

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