The Problem with Bonds
The Problem with Bonds
The bond markets of most western democracies have encountered significant inflationary headwinds in 2022 brought on by nascent inflation, of both the cost-push and demand-pull variety. Covid and its aftermath saw supply chains that reached deep into China and elsewhere become constrained and wages pressures increase. As price pressures have been passed on to end consumers, the risk of inflationary expectations becoming unanchored have increased and this has exercised the collective mind of central bankers the world over.
As the world has opened up post-Covid, stronger demand has intersected with less supply as geo-political tensions between Russia and the Ukraine have manifested into reality. The supply of food, fertiliser and energy as a result is particularly problematical. Even if a speedy resolution occurs between Russia and Ukraine, a rapprochement between Russia and the West will be a long time coming, thus adding ongoing structural price pressure on natural gas, oil and agricultural commodities.
Rising food and energy prices permeate all economic corners, inhibiting growth while putting ongoing upward pressure on bond yields. In highly interest rate sensitive economies carrying unprecedented levels of debt, we will discover how resilient these economies are.
For bond investors, this is not the full extent of headwinds, as central banks are winding back Covid-induced stimulus, meaning that one of the most significant buyers of bonds in the past two years will become sellers.
Another significant buyer for the past twenty years has been the rapid growth of index investing, or passive investment. Passive investing is indifferent to price - as passive funds have grown enormously, they are required to be fully invested in the indices they seek to replicate.
It is easy to discount the impact this forty year bull market in bonds has had on the growth of the passive bond industry. As yields decline, passive strategies offer a cost-effective exposure to such lower yields. When, for example the ten year US Treasury bond yielded as low as 0.50%, it becomes problematic for active bond managers to charge a management fee of, say, 0.20%.
While the microeconomic and geopolitical pressures on the direction of bond yields are both highly significant, bond markets around the world also have what could best be described as a “mathematical problem”.
As global debt levels have significantly increased in this millennia, so too have the durations of bond indices. Consider the following:
All other things being equal, if an investor in any of the above indices began investing in 2005, they now have an exposure to a much longer duration product than they initially invested in, as yields declined to levels that have never before been witnessed by history. The ten-year US Treasury bond yielded 4.48% on March 31, 2005. At March 31, 2022, the same bond yielded 2.33%.
This is a significant asymmetry. As bond yields have declined, index investors have experienced a lengthening in their duration exposure as governments issue more bonds, meaning that when bond yields rise, they lose more than the returns they gained when yields were declining.
Further compounding this risk to passive bond investing is the non-linear relationship between bond yields and bond prices.
What this means is that a buyer of a ten-year Treasury bond at 0.50% loses 18% of their investment if sold at 2.50% (approximately where the yield is today). At 5.00% (still below the current US inflation rate), that loss is 37%. While these prices do not allow for time decay, the magnitude of such losses is enormous when compared to running yields. It beggars belief that income-dependent passive bond investors would be willing to sustain such losses without redeeming their investment.
Yield curves are also inverting at the beginning of an interest rate tightening cycle, which is highly irregular and reflects a slowing growth environment coupled with rising inflation and interest rates. Such inversion also signifies a decline in bank credit creation due to long-term interest rates being lower than short term interest rates. This is a worst case scenario, and indicates a lack of economic resilience within the major economies of the world.
If structural inflation pressures persist, and central banks are forced to continue increasing official interest rates, passive index bond funds will continue to suffer negative performance. As developed world populations continue to age, they will be forced to redeem their passive exposures. That said, ageing populations is an oft factored reason by central bakers for lower rate trajectory cycles going forward. Witness Australia’s RBA Governor Phillip Lowe’s statements in this regard.
Just as passive bond funds are indifferent to price when buying index exposures, they are just as indifferent to price when they experience outflows. This “mathematical bond problem” could be the biggest problem of all if passive bond fund buyers become sellers. Other than central banks (who are currently signalling a willingness to reduce the size of their balance sheets), there are few natural buyers of bonds.
As the chart below from Minack Advisors shows, the US Treasury will need them.
Especially if passive bond funds turn from buyer to seller.