Last November 10th, I wrote how U.S. long bond yields were at
record lows in a bond market that had experienced, with some
interruptions, a record 30-year secular bull run. From the
double-digit peaks of interest rates in 1981 as the U.S. Federal
Reserve Board and other central banks sought to and succeeded in
breaking the back of inflation, rates have slid more than 10% from
each maturity point on the yield curve, down to below 3%, even for
the most volatile maturities.
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Mea Culpa, But Thesis Still Not Dead (Just
At the time I wrote the opinion piece, I contended that this very
long bull run in bonds was destined to come to an end, if not right
at that time, then soon. Well, 'soon,' in a historical
context, should we look back in hindsight a few months, quarters or
years from now, did not turn out to be imminent. There are a
number of possible reasons for that, which I will get into a bit
Rates have continued to fall, and the 30-year Treasury, which I
consider the true benchmark, now yields just under 2.6%. In
November, its yield was around 2.9%. The change is small, in
absolute terms, but important for capital appreciation. As
interest rates fall, bond duration increases and approaches that of
the bond's maturity.
Duration Rising, Important to Bond Returns
'Duration' is the present-value weighted average timing of the cash
flows of a financial instrument, such as a bond. A
zero-coupon bond has a duration equal to that of its
maturity. A change in interest rates for a zero-coupon bond
directly changes its price by the same percentage amount, times its
maturity. A 0.3% (30 basis point) change in the yield will
cause a 0.3% change in the price of the bond times its maturity,
or, in the case of a thirty-year zero-coupon bond, 9%. That
is a big move for a conservative investment, and in a short period
Treasury bonds are not principally issued in the zero-coupon mode
(they can be sold that way as 'strips' by investment
dealers). Yet their duration is already approaching their
maturity, and fast, as interest rates decline. At today's
30-year yield of 2.59%, the ('modified') duration is 20.68 years,
so a further 10 basis point drop in rates will provide a gain of
2.1%; 0.25% will provide over 5.1% in capital gain. The
less-than-current inflation coupon adds to the return.
For 10-year Treasuries, which yield just 1.5%, it is even more
pronounced. Their duration is 9.22, less than a year from the
maturity. A mere 5 basis point drop in rates gives a 0.46%
price appreciation; 10 basis points gives over 0.9%; a 0.25% drop
in yield will give 2.3%. As in the case of 30-year
Treasuries, these gains dwarf the actual coupon yield, and are most
of the total return to the investor.
So, investors -- including banks, pension funds, hedge funds, and
even ordinary individuals and corporations -- have made huge gains
in very secure fixed-income paper, backed in full by the U.S.
federal government with no chance of not being paid back, even if
it is with devalued. It's excess money created by the Federal
This has been going on for decades, but with some important -- and
unpleasant - interruptions, as interest rates occasionally
spiked. However, the last few years, since the financial
crisis led to the demise of many U.S. financial institutions, are
the most dramatic in sheer magnitude of the money at stake and the
returns that have been earned.
Motivations and Causes of Bond Buying
While some of the market participants may have been prescient
enough to realize that rates could go very low and thus generate
huge returns for bonds, even on a before-risk-adjusted basis, it
seems likelier that the motivations are diverse, and have changed
over the past four or five years.
Bonds As a Safe Alternative in Bad Economy,
The first impulse to buy bonds was that of safety. As
financial institutions became suspect, and the global economy
turned sour, the only assuredly safe place to put portfolio funds
was in bonds.
Federal Reserves Buys Bonds, Lowering Rates
The second motivation was the Federal Reserve's willingness to
provide liquidity, and then purchase U.S. Treasury and other bonds,
including mortgage-backed securities, in a program called
'Quantitative Easing,' which occurred in two programs, 'QE One' and
'QE Two,' and continues today in purchases of long-dated maturities
in the program called 'Operation Twist.'
The third reason interest rates on bonds have fallen is that banks,
in the U.S. and abroad, are finding it difficult to lend, and
demand for loans by customers is weak, because economic growth is
slow in most large economies, so the need for capital to expand is
Bank Regulation Changes, Treasury Buying Induced
The fourth reason interest rates remain low is that those same
banks have had greater restrictions placed on the quality of their
assets, quality which is risk-based. U.S. Treasuries are
considered risk-free (in a repayment sense), and do not require the
banks to shore up their capital reserves, because those securities
actually qualify as capital reserves.
Sovereign Debt Crisis Makes U.S. Preferred Bond Investor
The fifth reason rates have declined is the sovereign debt
crisis. Many national governments in Europe have experienced
difficulty paying expenses with tax revenue as of the recession,
and were unable to increase their borrowing to accommodate their
social welfare and bank bailout obligations. Most of these
nations use the Euro, so they were unable, unlike the U.S., the
U.K., Canada and Japan, to let their own currencies take part of
the financial burden away by devaluing, as they had in the past.
Several of these countries, principally Ireland, Greece and Spain,
had bank-debt-fueled real estate bubbles which had burst, leaving
bad loans on the books of banks, mass unemployment and even lower
tax revenues, plus higher social welfare expenses.
Rates had to come down in Euroland, and they have, but the Euro
itself has only slowly, erratically gone down in value. What
lowered U.S. rates, which might have been expected to rise to close
part of the gap between Treasury and Greek and Spanish rates, was
the dramatic drop in bond investment in Europe in favor of the less
unattractive environment of the United States.
While the U.S. fiscal situation has not been good for some time,
the damage to banks had been contained by 2009, and economic
growth, although weak, had resumed in that year. The European
sovereign debt crisis has only gotten worse, so U.S. and foreign
investors have continued to move money to North America.
Since the Treasury market is the biggest and most liquid in the
world, it remains the primary destination, although Switzerland and
Denmark have also benefited to the point where they can now sell
bonds with negative interest rates. Canada and Australia do
not have deficit, debt, growth, or solvency problems, but their
economies and currencies are subject to the whims of commodity
markets, and their market size is not large enough for big
investors. The Japanese bond market is huge, but yields are low,
and the country's fiscal outlook is bleak.
Slower Economic Growth Helps Bonds
The sixth reason bonds have performed well, and may continue to do
so, is that, starting in 2011, it looked like economic growth,
worldwide, was slowing down. This was partly due to
government stimulus measures in developed economies winding down,
partly to the European crisis, partly to China's efforts to cool
its own overheated and construction-dominated economy, and partly
to escalating energy prices dampening consumer spending. All
of these trends have persisted this year, although oil prices have
eased of late.
Recent U.S., Global Weakness Makes Bonds Outshine
The seventh reason bonds have shone so brightly is related to the
sixth reason. Stock markets began to falter last year as
economic growth began to slow, and the outlook deteriorated
further. Share prices move with corporate profits, which
cannot grow much if consumers and businesses are not experiencing
growth in income. Corporations have become more cautious, and
are not spending much in capital investment for renewal or
Another reason they are cautious is political, tax and regulatory
uncertainty, especially in the United States. That uncertainty will
continue until the Presidential election and likely beyond, as
several issues will remain no matter who wins control of the White
House, Senate or House of Representatives. So, bond markets
have looked better than stock markets, which could give negative
returns if profits decline or stagnate, or if they look like they
will do so, and for a prolonged period.
Bond Buying as a Winning, Profitable, Continued
The eighth and final reason that interest rates have declined so
much is that some investors and speculators are betting that they
will continue to do so; this is a self-fulfilling, and
self-reinforcing prophecy, one that has done so well for them for
four years now, and one that experienced, highly technically adept
and quick market experts can ride for some time to come, and get
out of quickly when it ceases to work for them.
It is, for them, another profitable bubble, whether or not they are
willing to consciously and explicitly admit it to themselves.
Also, as duration has increased as rates have fallen further, the
rate of decline in interest rates, as I showed earlier, does not
have to be as great for them to experience large gains. The
Federal Reserve is a willing, indirect accomplice in aiding this
process, since it helps accomplish their aim of suppressing
long-term interest rates despite those rates now becoming negative
in real terms; i.e., after inflation. This process is called
Leverage, Abetted by the Fed, Amplifies Returns, Return on
These sophisticated investors also have another tool at their
disposal, which magnify their gains: Leverage. They can
borrow at very low short term rates, at a small premium above that
of the U.S. federal government itself, putting only a fraction of
their own capital at risk, since their collateral is high quality
The return on capital they have been getting is enormous.
This can continue for quite some time further. Observers such
as myself thought that this would have ended long before now, but
as with all bubbles, the old adage regarding short-selling goes,
'Markets can be wrong longer than you can remain solvent.'