The British Bond market

[dusty88]

I assume at least a few people in this subforum share some of my concerns about the global economy and what the effect will be on us average people.

Interesting stuff last night in the British bond market. The BOE tried to initiate some more QE by buying longer term bonds and they couldn't get enough sellers. While nobody would personally want their low-interest rate sovereign debt, the fact is that some funds (especially pension funds) have to hold bonds. And the long term ones with slight yield at least provide some liability coverage; so they aren't going to let them go and have to buy more short term.

The way I see it, this is a case of MATH finally butting up against regulation and debt expansion. Is it the beginning of recognition of reality? I have no idea. I said a couple of years ago we would hit mathematical realities when interest rates finally hit zero. I was wrong; negative rates are apparently the new fashion of the decade.

I don't usually link Zero Hedge because they are just so negative.... but in this case they report it pretty concisely and the second story reports comments from multiple sources.

Batten down the hatches.

Bank Of England Suffers Stunning Failure On Second Day Of QE: "Goodness Knows What Happens Next Week" | Zero Hedge

Wall Street Reacts To The BOE's QE Failure | Zero Hedge

 

[T.Lex]

Yeah, hard to tell yet how big of a problem this will be. In a sense, it will depend on how WE react to it from a money policy perspective.

And that, I'm REALLY not sure of.

 

[dusty88]

Yeah, hard to tell yet how big of a problem this will be. In a sense, it will depend on how WE react to it from a money policy perspective.

And that, I'm REALLY not sure of.

I'm becoming more sure they are going to "helicopter" money at some point.

While we aren't quite at below-zero rates here, the stage has been set. Larry Summers was out villifying the $100 bill this year. If you are going to try to get people to keep using banks when you initiate negative rates, you have to get large bills out of circulation or even make large cash transactions illegal. The public isn't accepting that real well in Europe from what I hear so that may not work out. It certainly won't work to any great extent because people will choose a black market option instead. But they are clearly at least thinking about it.
We are also likely to see our bonds go negative rate as US bonds represent a perceived safety.

So, with central banks painted in a corner and unwilling to cry uncle, the next thing is some form of helicopter money.

 

[T.Lex]

I don't think we can really do negative bonds. I mean, we can tease it, we can float it, and try to influence investors that way, but actually doing it would create real political problems, IMHO.

But, I will concede that if negative rates are off the table behind the scenes, then the remaining options are limited and... less likely to be effective over the short/medium term.

 

[dusty88]

I don't think we can really do negative bonds. I mean, we can tease it, we can float it, and try to influence investors that way, but actually doing it would create real political problems, IMHO.

Several countries have negative bond rates right now. The thing is, bonds are rarely held long term by individuals. They are constantly bought and sold. If you are a fund manager and REQUIRED to hold a certain percentage of assets in sovereign bonds, then you have to buy them. The higher the price of the bond, the lower the effective yield. Interest rates are already really low so if demand for bonds goes up, the effective rate could become less than zero. With the US being the perceived place of safety, the bond funds could drive the effective rates below zero.

Negative rates in the bank for ordinary checking/savings accounts are a different story, but have been done by force in several European countries.

But, I will concede that if negative rates are off the table behind the scenes, then the remaining options are limited and... less likely to be effective over the short/medium term.

yeah, then it's reality or helicopter money and a different reality


BTW, Britain got someone to sell them a pile of bonds this morning, it appears. Another "almost" hiccup in the system. And I don't know if this has ever happened before.

 

[T.Lex]

Several countries have negative bond rates right now. The thing is, bonds are rarely held long term by individuals. They are constantly bought and sold. If you are a fund manager and REQUIRED to hold a certain percentage of assets in sovereign bonds, then you have to buy them.

Yes - I am VERY aware of that particular market.

Here in the states, those institutional investors have a great deal of influence and very good lobbyists (and attorneys). When you draw in the investment consultants and managers, you get alot of people with alot of money (both personally and what they control) which equates to influence.

Those pensions also have assumed rates of return. The assumptions underlying the ARR don't really allow for negative rates. If our bonds really went negative, you'd see an almost immediate effort to change asset allocations. That's IMHO, without having had any particular conversations about this topic with any decision makers.

 

[dusty88]

Yes - I am VERY aware of that particular market.

Here in the states, those institutional investors have a great deal of influence and very good lobbyists (and attorneys). When you draw in the investment consultants and managers, you get alot of people with alot of money (both personally and what they control) which equates to influence.

Those pensions also have assumed rates of return. The assumptions underlying the ARR don't really allow for negative rates. If our bonds really went negative, you'd see an almost immediate effort to change asset allocations. That's IMHO, without having had any particular conversations about this topic with any decision makers.

Oh sorry for assuming. You may know a lot more than I do (your field?). I'm used to having the bond conversation with people who can't understand why anyone would buy low-rate bonds.

You are suggesting the managers would be allowed to buy things that they currently aren't allowed to buy? If so, yes I hope so. It's particularly concerning for people depending on a pension, IMO.


.... and this whole thing makes me want to slap myself with a dose of reality.
Someone(s) are in possession of an agreement that says they get this teeny, tiny amount of return on their money. Someone offers to buy it from them. They should be saying "heck yes, take this loser off my hands!" and instead of wondering why the heck rates have gotten this low, we're playing games guessing if low-rate instruments will be worth even more because everything else is so screwed up.

For us ordinary people, that's what I would call trying to "beat the house" or trying to time things to make money at the end of a bubble. No thanks. I'm out.

(well Ok I'd like to be out but one can't exactly "get out" when one doesn't even know what the currency will be worth, huh?)

 

[T.Lex]

The pension funds generally have a fiduciary duty to the members to make decisions based on the exclusive benefit to the members. (You probably already know this, but I'm also playing to the larger audience here.) I would say most of the time, that flows to the managers, too.

You are absolutely right that debt - and specifically sovereign debt - is part of investment diversity. So, depending on the risk tolerance of the pension, that could be a relatively low or high amount. Whatever that allocation is, it is figured into the ARR with certain assumptions about what the rate will be.

Now, if bonds went negative, different pensions may have different rules about how to change their asset allocation, but the fiduciary duty would require the conversation at the board level and perhaps even the elected official level (again, depending on the fund). It would be a rare situation where the allocation is set by law, which would require a big process. I believe it is usually committees/boards/directors that can modify it.

For instance (quick googling), CalPERS, one of the largest and most influential public pensions, has 6% in inflation-hedge assets. This includes inflation-linked bonds. Couldn't immediately determine their fixed income assets beyond this, but it gives a sense of what their risk is of negative bonds.

 

[dusty88]

So the allocation can typically be modified as long as they put it in writing?

What about things like state government workers or teacher's pension funds? Still some flexibility? (nvm, I see you already referenced "public" pensions)

I believe I've heard some managers say that they cannot buy hard assets such as precious metals or land. But that could have been some very specific funds; it's NOT at all my field so I listen to or read random stuff. I've just found signals the last 10 years that tell me it is to my benefit to understand macroeconomics as well as of course investing choices.

 

[T.Lex]

So the allocation can typically be modified as long as they put it in writing?

What about things like state government workers or teacher's pension funds? Still some flexibility?

As with most large entities that have money, there's a process.

The process can be different, and there are alot of variations, but it would typically involve a Chief Investment Officer briefing either a director or a board of trustees or a state treasurer or some decision-making body on why this particular asset allocation is a bad idea. They would then make a decision to move away from certain assets to others. Now, some places might allow the CIO to do that on their own, within any given allocation. So, if the CIO has discretion to move from sovereign bonds to something else, they may do that without getting any specific approval. Depends on the fund.

During the collapse of the mortgage backed securities, you might've seen this play out where funds were getting out of anything that even smelled like RMBSs. The asset allocation gets modified - maybe on an emergency basis - to avoid losing money.

Now, the one caveat here is that there might be a small chance that any particular CIO might think negative rates are better than the alternative. I would think that to be unlikely. Cash/liquidity would be better than negative rates IMHO.

I believe I've heard some managers say that they cannot buy hard assets such as precious metals or land. But that could have been some very specific funds...

Obviously, there's alot of volatility in those markets. Pension funds tend to play long-game strategies that resist those kinds of investments.

"Land" though, in the sense of real estate trusts or the like, are a legitimate long-term strategy to mitigate risk. There may also be some risk-parity strategies that involve these kinds of assets, but they tend to be aggregated.

https://en.wikipedia.org/wiki/Risk_parity

Of course, you'll see bonds play a role in those strategies, too.

 

[Jackson]

Several countries have negative bond rates right now. The thing is, bonds are rarely held long term by individuals. They are constantly bought and sold. If you are a fund manager and REQUIRED to hold a certain percentage of assets in sovereign bonds, then you have to buy them. The higher the price of the bond, the lower the effective yield. Interest rates are already really low so if demand for bonds goes up, the effective rate could become less than zero. With the US being the perceived place of safety, the bond funds could drive the effective rates below zero.

Seems this would be a self regulating phenomenon. If the market flocks to bonds, driving up prices and depressing yields, the excitement over the bonds wanes and investors put money elswhere. Or are you saying the pension funds hold enough of this market to make it impossible to sell them and regulate bond prices?

If new bond rates decrease (or go negative), doesn't that increase the value of my existing bond portfolio?

 

[dusty88]

Seems this would be a self regulating phenomenon. If the market flocks to bonds, driving up prices and depressing yields, the excitement over the bonds wanes and investors put money elswhere. Or are you saying the pension funds hold enough of this market to make it impossible to sell them and regulate bond prices?

The funds that always hold bonds are certainly a factor, but the "market" hasn't been subject to market forces for several years now. There is so much central bank intervention that it's anybody's guess. For a while, those writing to that effect were outliers. Now even WSJ is posting commentaries about how nonsensical the market is.

Remember also that several countries have negative interest rates in savings accounts, so a slightly negative bond or a US bond (perceived perhaps to stay stronger than others) maybe is a taller midget.

If new bond rates decrease (or go negative), doesn't that increase the value of my existing bond portfolio?

Yes, just like years of the central banks purchasing bonds has been driving prices up. But don't you think that's a bit like being in 2006 and bragging how your real estate investments are still going up? Profits aren't profits until you realize them.

The "bond vigilantes" as they call them should have said no to these low rates by now, shouldn't they? But they can turn around and sell bonds to the central banks (at times?) and where else are they going to put their money?

It's a distortion pushed to the edge and even moreso in this case where the bondholders didn't even want to sell them to the BOE.

 

[T.Lex]

There is another dimension to this: scale.

Now, large institutions are treated differently than individuals. As an individual, I can buy a Treasury Bond or I can put my money in a low-interest savings account. Institutions don't really have that ability, because banks know who they are and have different fee structures.

So, when a large institution buys negative bonds - that is, they know they are going to get less money back than they put in - they are doing it because (this is my own overview, the specifics are much more complicated): 1) the negative rate is less than the amount they would pay in fees; and/or 2) there is risk that the bank may not have liquidity for large amounts of cash.

Playing a role in this, too, are the new-ish regulations about reserves. After the Great Recession, large institutions are required to have more reserves - money they can't commit to things. So, they HAVE to have cash/liquid assets, so they have to pay whatever it costs to do that.

They are also forced to loan more, to make more money (hopefully) to pay the higher fees/absorb the negative rates. But, to loan more, they either have to reduce their standards for borrowers or attract more of the better borrowers, which reduces profits.

The whole thing is a web, and better left with a minimum of regulation. But, that's not what "too big to fail" got us.

 

[dusty88]

Thanks for your input TLex. It helps reinforce my little pieces of understanding. I know some things, but I don't know what I don't know.... (where's rumseld when I need the proper unknowable vocabulary?)

Anyway, to expound on Jackson's thoughts about the ordinary guys' bond funds: for me, this goes to not investing in things you don't understand. I don't know how to evaluate a large corporation or a sector. So I don't buy individual stocks. If I buy sector funds, I think that I've chosen a manager that knows my sector so I "understand" I'm giving him the reins for a little piece of my portfolio. When I invest in index stock or bond funds, I'm operating on the idea that I understand what generally happens to these markets over time (ie I'm an investor not a trader).

But right now the markets aren't responding to market forces, so I have to say I don't understand them and shouldn't be in them. And yet it is a gamble not to be because you have to put them somewhere, and for most of us a lot of that "somewhere" is limited largely to retirement account products.

 

[T.Lex]

Thanks for your input TLex. It helps reinforce my little pieces of understanding. I know some things, but I don't know what I don't know.... (where's rumseld when I need the proper unknowable vocabulary?)

Anyway, to expound on Jackson's thoughts about the ordinary guys' bond funds: for me, this goes to not investing in things you don't understand. I don't know how to evaluate a large corporation or a sector. So I don't buy individual stocks. If I buy sector funds, I think that I've chosen a manager that knows my sector so I "understand" I'm giving him the reins for a little piece of my portfolio. When I invest in index stock or bond funds, I'm operating on the idea that I understand what generally happens to these markets over time (ie I'm an investor not a trader).

But right now the markets aren't responding to market forces, so I have to say I don't understand them and shouldn't be in them. And yet it is a gamble not to be because you have to put them somewhere, and for most of us a lot of that "somewhere" is limited largely to retirement account products.

Actually, the process you describe is very similar to what large institutions do - so you've got that going for you. They spend TONS of money on researching a particular market or sector or index, including expensive consultants. Then they research the managers to determine if there are any strategies that are "better" (under whatever criteria) than others. And even then, there are no guarantees.

So, ultimately, yeah, it depends on risk tolerance and diversification (or the ability to diversify). Nowadays, cash is not a bad allocation, then look opportunistically as something becomes known/understood. Now, that's contrary to the conventional wisdom of put the money in and let it sit for a long time - and there is still a place for that strategy - but we are in somewhat unfamiliar financial waters.

 

[dusty88]

Actually, the process you describe is very similar to what large institutions do - so you've got that going for you. They spend TONS of money on researching a particular market or sector or index, including expensive consultants. Then they research the managers to determine if there are any strategies that are "better" (under whatever criteria) than others. And even then, there are no guarantees.

So, ultimately, yeah, it depends on risk tolerance and diversification (or the ability to diversify). Nowadays, cash is not a bad allocation, then look opportunistically as something becomes known/understood. Now, that's contrary to the conventional wisdom of put the money in and let it sit for a long time - and there is still a place for that strategy - but we are in somewhat unfamiliar financial waters.

yes, we "bought and held" for decades and it worked out pretty well. But I don't think these times are the same.

We do have some cash but as you probably know the "cash equivalent" in the retirement accounts have now been largely shifted to short term treasuries. At the moment those are "cash equivalent". I'm not sure if that will ever present a problem or not. I suppose if there is an issue with short-term treasuries then the $$ is screwed anyway so it doesn't matter. The larger problem is if one really feels that it's time to grab ahold of hard assets, you pretty much have to make a 401k withdrawal or the onerous self-directed IRA.

Of course, I'm not putting much in the retirement accounts the last few years either; just taking advantage of any matching.

 

[T.Lex]

I hear you.

Whenever it starts getting too negative, I remind myself of something a finance person told me years ago. "If you're diversified by market, and have mutual funds or the like, if they ever all tank at the same time, you'll be more worried about finding clean water than what your portfolio is doing." Or something like that.

I would encourage you to find an investment consultant/broker that you trust. The good ones really know what they are doing and listen to what your needs are.

 

[dusty88]

I hear you.

Whenever it starts getting too negative, I remind myself of something a finance person told me years ago. "If you're diversified by market, and have mutual funds or the like, if they ever all tank at the same time, you'll be more worried about finding clean water than what your portfolio is doing." Or something like that.

I would encourage you to find an investment consultant/broker that you trust. The good ones really know what they are doing and listen to what your needs are.

I do need someone at some point, especially before we get closer to retirement and need withdrawal strategies.

The ones I've spoken with the last couple of years don't share my concerns of the market. They called it "fear" and my unspoken response was "I can do math". I'm not the newbie that doesn't get the fact the market goes up and down; we were in it solid for over 20 years. And I don't need some guy 20 years younger than me telling me to ignore macroeconomics.

I wish I could just ignore it, but I can't. That would be like thinking social security is going to take care of me.

And I do have a water supply
I do recognize that if there is a major economic shift that the balance sheet numbers we are used to aren't going to matter, so I don't think entirely in those kind of terms. IOW, if everybody is broke it's going to cost a lot less to buy a mule.