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Ten Things to Know About Negative Bond Yields
Old 02-28-2015, 08:05 AM   #1
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Ten Things to Know About Negative Bond Yields

I just came upon this interesting piece by Mohamed El-Erian

10 Things to Know About Negative Bond Yields - Bloomberg View

What I found particularly interesting were his points 9 and 10.

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9. There are few analytical models, and even fewer historical examples, to help understand the broader economic, financial, political and social implications of all this -- particularly for a global financial system based on the assumption of positive nominal rates. We are truly in unchartered waters.

10. The ultra-low interest rate regime is likely to persist for now. In the medium-term, this historical and highly unusual phenomenon is likely to bring not just possible benefits for the European economy but also much higher risks of collateral damage and unintended consequences. Accentuated by the illusion of market liquidity, this is a world in which small adjustments in probabilities of future outcomes -- if and when they occur -- could result in sharp movements in asset prices.
If he is correct about this, its seems to me that it calls into question the reliability of any model, like FIRECalc, that does assume the historical case of positive bond interest rates and, concomitantly, lower volatility. It may not turn out to be the case that bonds act as a portfolio stabilizer.
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Old 02-28-2015, 08:42 AM   #2
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So what is the alternative?
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Old 02-28-2015, 08:51 AM   #3
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So what is the alternative?
I suppose the alternative to holding bonds is to hold cash. I don't know what the alternative is for modeling based on historical data, except employing a monte carlo simulation and change the assumed rates and volatility as appropriate (your guess on "appropriate" is as good as mine.)
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Old 02-28-2015, 08:53 AM   #4
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So what is the alternative?
Cash in your mattress. Safe deposit box? Real estate? Food? Ammo? [MOD EDIT]
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Old 02-28-2015, 08:56 AM   #5
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It may not turn out to be the case that bonds act as a portfolio stabilizer.
I also found this article to be quite interesting. There is no doubt that you may turn out to be correct. The main thrust of the article is that we are in unchartered waters and can expect some surprises in the future. That makes destabilzation of portfolios from their bond holdings a definite possibility.

The trouble is that it's equally possible to infer the exact opposite conclusion from the same ten point article. Point #8 in particular emphasizes the relative attractiveness of U.S. government debt when compared to the negative yields that are popping up all over Europe. This issue alone could cause U.S. medium and long term bond yields to remain stable or even fall some more at the same time as the Federal Reserve starts raising short term interest rates. That may make long term treasuries one of the very best investments in the next few years.

Or maybe not. The problem with articles like this is that they can be interpreted in a million different ways. I personally think that point #10's reference to "sharp movements in asset prices" is just as likely to mean a major stock market correction as carnage in the bond market. But El-Erian was clearly careful not to single out either stocks or bonds when talking about "sharp movements", so who knows what it means? If El-Erian has an opinion about how negative bond yields should affect one's asset allocation, he certainly isn't sharing it with his readers.
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Old 02-28-2015, 09:04 AM   #6
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Or maybe not. The problem with articles like this is that they can be interpreted in a million different ways. I personally think that point #10's reference to "sharp movements in asset prices" is just as likely to mean a major stock market correction as carnage in the bond market. But El-Erian was clearly careful not to single out either stocks or bonds when talking about "sharp movements", so who knows what it means? If El-Erian has an opinion about how negative bond yields should affect one's asset allocation, he certainly isn't sharing it with his readers.
I also had difficulty divining whether he meant just bonds or other assets with that comment. It is unclear, but I don't know whether that is intentional or just poor writing.
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Old 02-28-2015, 09:12 AM   #7
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I also had difficulty divining whether he meant just bonds or other assets with that comment. It is unclear, but I don't know whether that is intentional or just poor writing.
I interpret that to include equities and other major asset classes, and think the phrasing is deliberate.
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Old 02-28-2015, 09:19 AM   #8
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Perhaps the fact that yields have gone negative in some instances is not the issue per se but that hovering so very close to zero greatly magnifies the effect of changing probability assessments. As so often occurs, I could be wrong, but it seems to me that, mathematically, the effect of going from .0001% to .0002 % yield on a bond has the same affect on principal value as going from 3% to 6% and is far more likely to occur.
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Old 02-28-2015, 09:50 AM   #9
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I think #3 is relevant:

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The seemingly illogical willingness of investors to pay issuers to borrow their money is neither irrational nor driven by just noncommercial considerations (such as regulatory requirements or forced risk aversion). As the European Central Bank prepares to start its own large-scale purchasing program next week, some investors believe they could make capital gains on such negative yielding investments.
If they're betting market price changes driven by central bank actions, then it seems these negative yields can't last. Eventually, the bank's actions are known and capital gains expectations settle down.
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Old 02-28-2015, 11:10 AM   #10
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I suppose the alternative to holding bonds is to hold cash.
I'd rather not, thanks. I don't doubt that German bonds may be in trouble at the moment, definitely interesting information and much appreciated. Still, according to Vanguard, 2014 returns before taxes for VBTLX (Total Bond Market Index) were 5.89%, and for VWIAX (Wellesley, which is 62.6% bonds) they were 8.15%. At the present time those returns are not low enough to push me towards cash.

Now, when I was in the accumulation phase, my AA was 100% equities.

As for FIRECalc, I think it is a very good retirement planning tool and like all models, should be used as a supplement (not a substitute) to one's other retirement planning information.
"essentially, all models are wrong, but some are useful" - - George E. P. Box (1919 – 2013). That just cannot be emphasized enough in any modeling discussion. If FIRECalc tells a potential retiree that he/she had better go back to the drawing board, then I think that it would be advisable to do that - - to do some checking and re-thinking. That's a good use for it.

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I interpret that to include equities and other major asset classes, and think the phrasing is deliberate.
Yes, it got our attention, didn't it! And that can be an objective in itself, sometimes.
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Old 03-01-2015, 07:48 AM   #11
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mathematically, the effect of going from .0001% to .0002 % yield on a bond has the same affect on principal value as going from 3% to 6% and is far more likely to occur.
I'm afraid that's not how bond pricing works. If you have the option of buying, say, a ten year bond yielding .0001% or another one yielding .0002%, you would be willing to pay less for the bond with the lower yield. But the amount of the price discount that you would demand depends on the time weighted cash flows you would be receiving. In this example, $1 million invested in ten year bonds yielding .0002% would pay $2 in interest every year. After ten years you would have received $20 in interest payments plus the $1 million in principal for a total of $1,000,020.

With that in mind, how much should you be willing to pay for $1 million in bonds yielding only .0001%? It works out to approximately $999,990. That's because after ten years you would get a total of $10 in interest payments plus the $1 million in return of principal, for a total of $1,000,010. You would have made the same $20 profit as the investor who paid a full $1 million for the higher yielding bonds and would be satisified that you both got approximately the same value on your investment.

So, tiny changes in interest rates result in tiny changes in bond prices, no matter what the coupon rate is on the bonds. Now, going from a .0001% yield to a 6% yield is another matter. If you expect interest rates to eventually stabilize at 6%, then making a ten year investment at .0001% probably doesn't make a lot of sense, unless you expect interest rates to stay near zero for about nine years and 11 months. That's why investor's expectations are so important in bond pricing. Right now a lot of European investors are expecting rates to remain low for an indefinitely long period. When those expectations change, these zero and negative rate bonds are going to be discounted accordingly. The European central bank has a daunting challenge ahead of it to manage expectations in an orderly manner, much harder than what the Federal Reserve is facing in the U.S.
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Old 03-01-2015, 07:57 AM   #12
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Cash is essentially a bond with a nominal interest rate of 0%.


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Old 03-01-2015, 08:08 AM   #13
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Without the ECB QE in effect, we have near zero interest rates all across Europe except in Greece which only a drunken monkey might believe they will get 100% from their Greek bonds. This leads to the obvious question of what is the ECB planning to accomplish with QE? If low interest rates by themselves caused economic growth, the euro zone would bury the US in GDP growth. I can't help seeing any ECB QE as nothing other than under the table Greek funding.

From a practical standpoint the only people who should accept negative interest rates would be large financial organizations that physically can't hold large amounts of cash. From a different view, people may be willing to buy less than zero German bonds in the expectation or hope that the euro collapses and Germany reverts back to the DM. The new DM would be expected to surge creating massive capital gains for the euro to DM converted bonds. It would be Grexit in reverse.
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Old 03-01-2015, 09:57 AM   #14
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Negative yields is much ado about nothing. Rates are at zero and sometimes noise in the system pushes them below. It's unsustainable, and sensational fodder for news people. Macro Economically, rates cannot push past zero at any level of significance.


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Old 03-01-2015, 12:19 PM   #15
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Negative yields is much ado about nothing. Rates are at zero and sometimes noise in the system pushes them below. It's unsustainable, and sensational fodder for news people. Macro Economically, rates cannot push past zero at any level of significance.
It depends on what you mean by "any level of significance". Two year German government bonds closed at a -0.23% yield on Friday. I would call that a lot more than "noise" in the system, but perhaps you have a different definition of noise.

German Government Bonds - Bloomberg

I can think of at least three reasons why bond yields might go significantly negative and stay negative for prolonged periods - 1. expectations of even bigger negative yields in the future leading investors to hope for capital gains, 2. fear of deflation making negative nominal yields turn into potentially positive inflation adjusted yields, and 3. currency speculation with investors hoping that the strength of the currency outweighs negative yields. El-Erian explicitly mentioned 1. in his article and touched briefly on deflation. As for 3., negative yields in Switzerland are probably related to the strength of the Swiss franc, although it's harder to explain negative yields in Germany this way.

Overall, I consider 1. to be a sign of an asset bubble, but 2. to be a rational response to deflation fears. So my guess is that investors are betting that the ECB is much less likely to win the battle against deflation that the Federal Reserve.
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Old 03-01-2015, 02:09 PM   #16
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I'm afraid that's not how bond pricing works. . . .
Thanks for that explanation, Karluk. I have learned something new.
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Old 03-01-2015, 02:53 PM   #17
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I can think of at least three reasons why bond yields might go significantly negative and stay negative for prolonged periods - 1. expectations of even bigger negative yields in the future leading investors to hope for capital gains, 2. fear of deflation making negative nominal yields turn into potentially positive inflation adjusted yields, and 3. currency speculation with investors hoping that the strength of the currency outweighs negative yields. El-Erian explicitly mentioned 1. in his article and touched briefly on deflation. As for 3., negative yields in Switzerland are probably related to the strength of the Swiss franc, although it's harder to explain negative yields in Germany this way.
Good list. I would add a reason. Large institutional investors and banks have mandated or self-imposed restrictions on which asset classes they can invest in, they feel that some sovereign debt is still risky even when backed by the ECB, so they choose the sovereign debt they feel is truly safe, even at the expense of short term yield. For banks and institutions, safety is (or can be) much more critical than yield.

One question we should ask is, if it is critical for them, why is it not so for us?
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Old 03-01-2015, 02:57 PM   #18
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Originally Posted by urn2bfree View Post
Cash is essentially a bond with a nominal interest rate of 0%.


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No. Cash pays interest. Some even pays 1%.

Cash has no credit risk or interest rate risk or maturity, or possibility for capital gain, so you can't model it as a bond.
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Old 03-01-2015, 03:02 PM   #19
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On El Erian - he has always seemed like the vague hand wavy sort. I don't think you can pin him down.
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Old 03-01-2015, 09:08 PM   #20
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No. Cash pays interest. Some even pays 1%.
Can you elaborate on this? The $40 in my wallet doesn't spawn pennies (that I've noticed).
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