The vernacular of the bond market is trader – not investor – focussed

And so I return from a short outing to the Northern Colony and what a joy it was. For all its many failings, I do always find Scotland to be most welcoming and I cannot deny harbouring a little envy for the Scots’ demonstrable and proud sense of identity. Today is of course July 4th, Independence Day in the United States, and the day on which our transatlantic cousins demonstrate just that. It is the day on which they all cease being Italian-American or Irish American or whatever and are all just American. Identity politics can for one day be laid to rest and communality can be celebrated over diversity.

My “mini-break” was briefly interrupted by my having remotely joined the quarterly investment committee meeting which I refer to from time to time and thank heavens for the miracles of modern communications technology. One minute discussing the whichness of the why, an hour later tucking into a plate of venison at the Scottish Game Fair in the grounds of at Scone Palace on the fringes of Perth. The IC meeting was of particular interest to myself as I had been co-opted onto the committee over 10 years ago as a specialist on bonds and had spent nearly all of them bemoaning the decline in yields and the increasing unattractiveness of both government and credit markets. But the world is changing, rates are rising and we have rejigged our strategic asset allocation which has returned the fixed income proportion of the various portfolio objectives to a meaningful contributor to income rather than just a necessary evil.

I intentionally use the word “income” and not “performance”. It’s hard to believe that I have been fiddling around in bond markets since most of the current stars on the trading floors of the City and Wall Street were still in short trousers and in many cases since before they were even born. That does not make me any better than them but it does mean that I have maybe had a little longer to separate the hard facts from the hype and regular readers will be aware that I have repeatedly argued that one of the reasons we keep on hearing that plaintiff moan of “I don’t understand bonds…” is that that the vernacular of the bond market is trader and not investor focussed. Please let me explain.

We all love equities. We can see the price going up and down and that is for all intents and purposes easy. The price of the share is determined by a bunch of guesses – whether educated or not is moot – with respect to future dividends. These are essentially unknown so, and with no disrespect, stock prices are emotional. Recent events such as the hijacking of certain meme stocks such as GameStop by the Robinhood community demonstrated just how powerful demand and supply are over actual value. Didn’t we all watch The Wolf of Wall Street? Leo de Caprio, Jonah Hill, Margo Robbie and dwarf tossing aside, Jordon Belford made a fortune by flogging worthless stocks to people who believed the money to be lying on the street. The meme stock craze proves that if enough people can be conned into leaping on any given bandwagon, all the MBAs’, CFAs’ and ACAs’ analysis in the world counts for nothing. I believe it was none other than John Maynard Keynes who, having puffed the family fortune in the Crash of ’29, concluded that one does not make money by buying stocks that are cheap but by finding ones which are going to prove to be popular. I digress.

Bonds are not speculative. They get issued at par – that’s 100 cents in the dollar – and at a fixed future date, defaults excepted, they will redeem at par. In the meantime they will pay a fixed amount of interest on a known date, conventionally every six months, from the date of issue until the day they the redeem. That’s it. If the issuers have paid all their coupons in a timely fashion and have repaid the capital on the allotted date, then they have done what it says on the tin. The coupon on every bond is set at issue in accordance with where interest rates stand on that day and, irrespective of what happens to underlying interest rates between then and the end of the bond’s life, the terms remain unchanged. Thus, if underlying rates fall, the bond with a higher coupon is comparatively worth more. If rates rise, it becomes comparatively worth less. Note the word “comparatively”. In the market, all bonds are priced comparatively to other bonds. The vocabulary of bonds, be that yield, duration or convexity or the many other arithmetic formulas applied to bonds have little purpose other than to try to meaningfully compare them with one another.

Take two gilts, two treasuries, two bunds or two notes issued by Shell, Ford or the government of Ghana with the same maturity but with different coupons. The difference in price will do nothing other than attempt to bring the return onto an equal footing so that a putative buyer can acquire either of the two to an identical effect. That is of course entirely theoretical as all the calculations, beginning with the most basic which is yield to maturity, assumes that future cash flows, that’s the semi-annual coupon payments, will all be able to be reinvested through to the final maturity of the bond at one and the same rate. So, a ten year bond pays its first coupon after six months and the reinvestment rate for the next nine and a half years is, in the yield to maturity formula, assumed to be the same as the ten year rate was at issue. And the same again six months hence. And again six months later and so on and so forth and the final coupon, paid after nine and half years, is also assumed to have been reinvested for six months at the rate which applied to a ten year investment nine and a half years ago. This is quite evidently total rubbish and so the most basic calculation underlying the entire global bond market essentially belongs in the same category as “Of course I’ll still love you in the morning” and “The cheque’s in the mail”.

Please don’t get me wrong; I’m not denigrating bond markets which in one way or the other fed me and paid my mortgage for many decades but I’m warning from falling victim to believing in the concept of total return, a measure most successfully promoted by Bill Gross, the billionaire co-founder and long-time chief investment officer of the Pacific Investment Management Company, more commonly known by its acronym Pimco. Total return in fixed income assumes that in a falling interest rate environment older bonds with higher coupons are worth more and that the increase in price, although only reflecting a shift in relative but not absolute value, can be reported as a profit and the fund managers can in consequence pay themselves a hefty bonus. 

Gross, now no longer with Pimco, is assumed to be worth something in the region of US$1.5 billion and, as the saying goes, “Where are all the customers’ yachts?”. Riding a falling interest rate environment and taking credit for it is easy and although many a fund manager got rich doing so, it did the end investors no good at all. What is so exciting about seeing every redeemed bond replaced with one with a lower coupon and what is so exciting about coupons having to reinvested at ever lower rates? As rates fell, fixed income portfolios were theoretically and on a mark-to-market basis making huge returns whereas in reality the market was becoming ever less attractive. And then rates hit rock bottom, total returns went negative and after a decade or more bonds are finally beginning to look like a compelling investment prospect.  

My colleagues on the Investment Committee, some of whom have been there since I was first appointed, will remember that for the full decade I  have argued that until the 10 year rate returns to at least 4%, bonds are not really worth investing in. 10 year UK Gilts are as at now 4.43% and 10 year US Treasuries are at 3.85% and within sniffing distance of the 4% threshold.  Any US Treasury with a maturity of less than 5 years does, however, pass the test.  

The above explanations are of course simplistic, maybe even over-simplistic, but they are aimed at reminding that a bond is about paying its fixed coupon when expected and returning the holder’s capital at maturity. In September of 2017, the Republic of Austria issued a 100 year bond with a coupon of 2.1%. As yields fell, especially during the pandemic when underlying European rates went negative, the price of the bond shot up to over 210 cents in the euro. What never changed, however, was the 2.1% coupon.  As at the time of writing the bond is trading on a yield of 2.455% – it has been higher – and therefore at a hefty discount to its issue price; it is now quoted at 42 cents in the euro. What has not changed and never will is that it will pay a coupon of 2.1% from today and until the Republic returns investors’ capital in the year 2117. How much € 1,000,000 will be worth in real terms in 2117 is debatable but do we really care seeing as none of us nor our wealth managers who so eagerly bought the thing will still be here?  Apres moi la deluge.    

Equities trade with the market trend but are essentially idiosyncratically priced. Bonds are not. They rise and fall with the market. In a positive yield curve environment, generally referred to as a normal curve, when committing longer dated capital is rewarded by higher coupons – not currently the case – investors can capture the roll-down which is done by selling for example an originally 10 year bond with 5 years left to run at the prevailing lower 5 year rate and re-investing in a new, higher yielding 10 year. Doing this well is a skill but it is not rocket science although some poor sod owns a 2117 Austria bond at a low yield of 0.4%. The roll-down might work in 2115. Whoever was in charge at the Austrian Federal Financing Agency at the time of issue deserves a medal; anybody who actually invested their clients’ money which they managed under a fiduciary covenant in it should be hung, drawn and quartered. They clearly fell victim to being confused by applying traders’ thinking and vocabulary which dominate the bond markets and which they applied to the process of investing other people’s money.

So I sat through the IC meeting and noted with some satisfaction that much of what I had been arguing year in, year out, had not been falling on deaf ears and that the time has come when bonds will most likely not be delivering a regular and reliable mark-to-market profit but will on the other hand be providing a meaningful contribution towards our clients’ cashflow. And that is what bonds are supposed to do.

Write to us with your comments to be considered for publication at letters@reaction.life