Tyndall Monthly Commentary: Bondholders risk euthanasia

Eighty years ago, in the depths of the Great Depression, the economist Maynard Keynes suggested that in a world of freely floating currencies and bank financing of large government fiscal deficits, bond yields could be forced down to the zero bound or beyond, thereby impoverishing the bondholder or rentier class.  He also suggested that once interest rates started to rise once again as the world ultimately returned to normal, the unfortunate bondholder would then suffer significant capital losses as well.  Given the gearing effect of ultra-low bond yields on bond prices, even a modest back-up in bond yields from a very low level to simply “a less low level” can impose very significant capital losses on bondholders and particularly on those who must “mark to market”.

Today, three generations after Keynes’ pondered this potential “euthanasia of the rentier class”, we do have incredibly low bond yields and we suspect that in many if not all of the world’s larger economies, yields are now so low as to be a problem for the end user investors (be they individuals or pension funds) and, in particular, for their actuaries.  Moreover, given the potential for bondholders to experience large capital losses if and when the global economy finally does return to a more even keel, one could suggest that the risk-reward calculation for holding long term investment-grade bonds is currently not an attractive one.  In fact, only if one believes that actual deflation or at least ”below target rates of inflation” are possible, can one really contemplate holding long-term government bonds at this juncture, unless one is otherwise compelled to do so by the rising tide of financial regulation and repression.

Certainly, given this situation, we are not surprised to find that many investors are indeed quitting the bond markets at present.  Many of the world’s banks, insurers and other financial entities are being obliged to stay in the markets as a result of regulatory regimes and collateral requirements (it is somewhat ironic that they are being pushed into what are notionally safe assets but which actually now have a questionable price outlook) but where investors are free to move, they are moving away from bonds and chasing risk assets, be they equities, junk bonds, property assets or currencies of countries that they might struggle to find on a map! 

Last week, we met with the head of a medium-sized bond brokerage business who expressed delight (that is, in the rising commissions) but also horror at some of the “stuff” that his clients were moving into; trades out of AAA Bunds into junk denominated in exotic currencies are now commonplace.  In fact, we suspect that it has been this process that has provided much of the impetus and momentum for risk markets over recent weeks and certainly for the improvement in Europe’s peripheral debt markets.