Who’s scary now?
The bond market is transformed: fewer vigilantes; more forced buyers
JAMES CARVILLE, political adviser to Bill Clinton, the former president, famously said that he wanted to be reincarnated as the bond market so he could “intimidate everybody”. He was frustrated by the administration’s inability to push through an economic stimulus for fear of spooking investors and pushing bond yields higher.
More than 20 years later, the world looks very different. Many developed countries have been running budget deficits ever since the global financial crisis of 2008; their government debt-to-GDP ratios are far higher than they were in the early 1990s. Yet the bond market looks about as intimidating as a chihuahua in a handbag; in general, yields are close to historic lows.
In the 1990s “bond-market vigilantes” sold their holdings when they feared that countries were pursuing irresponsible fiscal or monetary policies. In Britain even fear of a “hard Brexit” is only now being reflected in rising gilt yields—and they are still below the (very low) levels seen before the vote to leave the EU in June. Even developing countries with big budget deficits can borrow easily. This week, for example, Saudi Arabia tapped the markets for the first time, raising $17.5 billion—the largest-ever emerging-market bond issue.
Vigilantes have become vastly outnumbered by bondholders with no real interest in maximising the return on their portfolios. Central banks have been the biggest factor in the market’s transformation.
After the crisis, they turned to quantitative easing (QE), ie, expanding their balance-sheets by creating new money in order to buy assets. The collective balance-sheets of the six most active (the Federal Reserve, Bank of Japan, European Central Bank, Swiss National Bank, Bank of England and People’s Bank of China) have grown from around $3 trillion in 2002 to more than $18 trillion today, according to Pimco, a fund-management group. These central banks want to lower bond yields—indeed, the Bank of Japan intends to keep the ten-year Japanese bond yield at around 0%. Instead of acting as vigilantes patrolling profligate politicians, central banks have become their accomplices.
Then there are pension funds and insurance companies, which buy government bonds to match their long-term liabilities. Neither group has an incentive to sell bonds if yields fall; indeed, they may need to buy more because, when interest rates are low, the present value of their discounted future liabilities rises. Banks, too, play an important role. They have been encouraged to buy government bonds as a “liquidity reserve” to avoid the kind of funding problems they had in the 2008 crisis. They also use them as the collateral for short-term borrowing.
Yielding to none
With so many forced buyers, trillions of dollars-worth of government bonds are trading on negative yields. “When you have so many price-insensitive buyers, the price-discovery role of the market doesn’t work any more,” says Kit Juckes, a strategist at Société Générale, a French bank.
If central banks are willing buyers of an asset, that asset is as good as cash for most investors.
So like cash, government bonds generate a very low return. Always true of the shortest-dated bonds, to be repaid in a few weeks or months, this now applies to a much broader range; two-year debt yields are negative in Germany and Japan and below 1% in America. Open-market operations, in which central banks buy and sell securities, used to focus on debt maturing in less than three months; now they cover bond yields at much longer maturities.
This new-style bond market has created a problem for those who run mutual funds or who manage private wealth—and who do care about the return. Large parts of the bond market no longer offer the rewards they used to. As each year begins, polls show that fund managers think bond yields are bound to rise (and prices to fall); each year they are surprised as yields stay low. “When your old-fashioned pricing model doesn’t work, how do you decide when the asset is cheap?” asks Mr Juckes.
In practice, such investors have been forced to take more risk in search of a higher return. They have bought corporate bonds and emerging-market debt. And in the government-bond markets they have bought higher-yielding longer-term debt.
A key measure of risk is duration; the number of years investors would take to earn back their money.
In Europe the average duration of government debt has increased from six to seven years since 2008, according to Salman Ahmed of Lombard Odier, a fund-management group. That doesn’t sound much. But the longer the duration of a portfolio, the more exposed it is to a rise in bond yields. Mr Ahmed reckons that a half-a-percentage-point rise in yields “would create significant and damaging mark-to-market losses”.
Another change in the bond markets exacerbates the problem: liquidity has deteriorated. There have been some sudden jumps in yields in recent years—the “taper tantrum” in 2013, when the Fed started to reduce its QE programme; and a surge in German bond yields in 2015, for example.
Banks may hold bonds for liquidity purposes. But because they are required to put capital aside to reflect the risk of holding corporate debt, they have become less keen to own them for market-making, or trading. Before 2008, bond dealers had inventories worth more than 2% of the corporate-bond market; now their inventories are only a tenth of the size, in relative terms (see chart).
So should a large number of bond investors decide to sell their positions in risky debt, buyers will be scarce; prices may move very quickly. Yet it is not difficult to imagine reasons for a sell-off. If the Fed decides to push up interest rates more quickly than the markets expect, bond yields could rise across the globe. The same could happen if central banks in Europe and Japan decided they no longer wanted to buy government debt: such fears this month nudged up yields in Europe. Or investors might start to fret about the amount of credit risk they have taken. In the emerging markets, for example, more than half of corporate bonds are ranked as “speculative” or “junk”, and the default rate has been steadily rising.
In short, as Mr Juckes puts it, the bond market is “brittle”. It is priced for a world of slow growth and low inflation, leaving no margin for error if things change. The most intimidating thing about the modern bond market now is the risk that they do.