US Bonds Battered
The word “bond” is used ubiquitously across financial services. Today we are referring to bonds in terms of “fixed income” investments.
Fixed income investments differ from stocks, in that owning a stock entitles you to a share of a company’s revenue and earnings moving forwards. By owning a bond you are instead lending money to either a company or government in return for a) your money back at the end of a period of time and b) some interest along the way.
Bonds, like a lot of things, are as complicated as we choose to make them. Here’s what you need to know.
Bonds tend to exhibit less downside risk (in the short term) than stocks, but they also tend to generate much lower returns over longer time periods.;
Bonds tend to move in the opposite direction to stocks when the world is ending.;
When financial commentators discuss bonds, they quote the annual return said bond is currently offering (referred to as the “yield”) rather than the price of the bond. This can be confusing but there are good reasons for it;
People who spend their days analysing bonds for a living tend not to be much cop at a dinner party; and
Bonds leave you exposed to two specific risks. The first is “counter party risk” - you lend money to some entity, they go bust and therefore can’t afford to pay you back. The second is inflation risk - you loan money for say, five years, and during that period of time rising prices reduce the real value of the fixed annual interest return you receive from your bond investment as well as the repayment of capital you receive at the end.
With the stock market chugging along just fine thanks over the summer, the excitement has all been coming from the bond market - specifically the long dated US Treasury market.
When a bond falls in price, the yield (return) on offer increases. This is good news for income hungry new investors, less good news for existing holders and the borrower.
The net result of the above move is that long term borrowing costs for the United States are as high as they have been in the past twenty years.
Why is this happening? Well, it comes back to the two risks we identified in point 5 above.
There are two ways to lose money as a bond investor (lender). The party you loan money to goes bust, or inflation during the course of the loan erodes the purchasing power of your income stream and capital over time.
I’m not for a moment suggesting that the US government will go bust, but there has been a lot more focus recently on how much the US government actually owes. As of today, the US government has total outstanding debts of $40.1 trillion and rising.
All other things being equal, the more somebody borrows - the more that a lender should ask for in terms of interest to lend them any money. This is one explanation for rising interest rates.
The second is that inflation has been a bit more “sticky” in recent times than most economists suspected. And if prices are rising across the economy by more than expected, again any lender should demand a higher return on their loan to better protect the value of their money against inflation.
Should I care about any of this?
In a year where the stock market has done great and there hasn’t been much else to moan about, these kind of moves in the bond market are catnip to the usual suspects that see misery around every corner.
However there is no denying that the US is the heartbeat of the global economy, and when its borrowing costs hit twenty year highs it is sensible to take notice.
But equally - some context is needed.
US borrowing is not egregious in a global context.
$40.1 trillion is obviously an insane number.
But when we consider the impact this kind of debt should have on a country’s credit-worthiness, we have to place it both into the context of the amount of money said country makes (its GDP - Gross Domestic Product), as well as the equivalent level of debt held by the other countries which compete with America for investment.
So although the US holds the most debt by a long way, in the context of the amount of money the country produces every year this is not particularly unusual.
On this front Japan are the real outlier with a total debt to GDP ratio of 204%. The UK currently sits at 104% for the record…
Of all the countries listed, America should also in theory be able to borrow the most given that the Dollar is the world’s reserve currency. USD underpins the whole show.
Since the Great Financial Crisis US government debt has massively increased, but this has been more than offset by debt reduction in other parts of their economy.
Government borrowing cannot be viewed in isolation. It has to be viewed in the context of the wider economy.
And the good news for our friends across the pond is that although US government borrowing has increased massively as a percentage of the economy, household debt has been shrinking since the GFC.
With the net effect that the total amount of debt in the system as a percentage of GDP has actually been stable over recent years, and fallen significantly since 2009.
Within the US economy there has effectively been a cleaning up of household and corporate balance sheets, with most of that debt being transferred onto the government.
A government who has the ability to print money in the world’s reserve currency to pay their bills if it came to it.
Higher interest rates are good for investors!
Investor returns from bonds are far more predictable than from stocks. The best predictor of the long term return an investor can expect from a bond is the starting yield on that investment.
So if bond yields are rising, that means returns in the future should also be higher.
It wasn’t too long ago, in the post Financial Crisis zero interest rate era, that folks in retirement who needed their investments to generate an income to live off were basically forced to buy stocks - because bonds barely generated any kind of income.
That is absolutely not the situation today. Assuming the world doesn’t end, a starting global risk free rate in and around 5% doesn’t sound too bad to me.
For now at least, the stock market doesn’t care.
This sentence has a very high possibility of coming back to bite me.
But for now its a fact, its been a cracking year so far for equity investors and none of these moves in the bond market seem to be having a wholesale impact on share prices.
Stocks are the engine of growth within a diversified investor’s portfolio, and therefore they are what matters when it comes to the return side of the equation in most years.
Our fixed income exposure has two jobs within a portfolio really - to generate a steady income for us and to help dig us out when stocks are falling. With bond prices falling, future incomes will by definition be higher and the cost of our portfolio’s insurance policy is getting cheaper.
And all this while stocks are working. Call me naïve, but surely that’s a not a bad situation to be in?
Past performance is not indicative of future returns. None of the above is intended to represent investment advice to anyone. If you have specific queries regarding your situation, please consult with a regulated financial adviser.
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