- ?Rather than outright default, many countries attempt rather successfully to keep nominal interest rates lower than would otherwise prevail.
- Over the long term, this “financial repression” results in a transfer of wealth from savers to borrowers.
- Investors shouldn’t give their money away, and at the moment, the duration component of a bond portfolio comes close to doing just that – because it doesn’t yield enough relative to inflation.
Because the QEs cover an extraordinary period of monetary policy with a limited time frame, there is not enough data to indicate whether the end of QEII will lead to higher or even lower rates, although higher is our strong preference. “Who will buy them?” remains a critical question to be answered. There is, however, overwhelming evidence – now provided by Carmen Reinhart among others – that existing Treasury yields fail to adequately compensate investors for the risk of holding them, when measured on a historical basis.
yarns about jumping frogs, one which has been frequently told, the
other not so much. Neither of them have anything to do with Samuel
Clemens’ heralded short story, but both, metaphorically at least,
describe our current investment markets and how to think about the
future. My first story is the one you’ve all heard about. Put a frog in a
kettle of boiling water and he’ll jump out faster and further than any
of those blue ribbon winners at the Calaveras County jumping frog
contest. Put him in a pot at room temperature, however, slowly turn up
the temperature to boiling, and you’ll have frog legs for dinner. This
latter, more unfortunate toad temporarily adapted to his external
environment, which seemed like a practical thing to do, until – well,
until he reached 212° at which point he was cooked.
nary a “ribbet” of complaint. “Total returns” for the first five months
for almost all bond categories show positive price performance, which
when combined with coupon interest income, produce portfolios 3% or so
higher in value than at year-end 2010. That number may not match stocks
or some of the high-flying commodities, but its annualized total return
of 6½ –7% beats inflation however you want to measure it – core,
headline or median CPI. Well – as I frustratingly tried to explain to my
mother for years – this total return concept of price and yield appeals
primarily when yields come down and bond prices go up.
Think of bonds, Mom, as you would a teeter-totter, I would say.
Interest rates go down – bond prices up. Vice versa too, except that
beginning in 1981, the totter rarely teetered in the negative price
direction. Bull markets in bonds, stocks and real estate rode an asset
appreciation escalator that induced an artificial euphoria on the part
of many investors expecting the ride to never end. Even conservative
old-fashioned bonds – more famous for “coupon clipping” than capital
gains – were bolstered by this secularly positive, total return concept.
be heaven bound but have more earthly limitations. While stock values
are often complicated by growth rate assumptions and P/E ratios making
their ultimate destination uncertain, bond yields at least have a
mathematical zero bound below which they cannot journey for more than a
few nanoseconds. Investors don’t give up their money for the promise of less
money in return and so negative nominal yields are a mathematical
impossibility aside from fears of government confiscation and temporary
liquidity considerations. But here is where it gets tricky and where our
soon-to-be-boiled frog comes into play. Much like gradually turning up
the temperature on poor froggy’s kettle of water, monetary policy in
developed countries has been lowering the temperature and absolute level
of yields for the past 2½ years post Lehman Brothers. Teeter-totter
yields down, teeter-totter prices up, and froggy’s total return euphoria
at present seems to know no bounds. But once the potential for even
lower interest rates is minimized by the zero floor, our future
frog-legged entrée is left with a rather uncomfortable feeling. He’s
resting inertly in this caldron as prices near the boiling point with
the Fed, the Chinese and the banks all buying up whatever Treasury bonds
are offered. Everything appears well. But bond investors with a
survival instinct (being one and the same as our cooking frog) should
reflect on that old teeter-totter metaphor and realize that prices near
the boiling point automatically imply yields near subzero. Granted,
5-year Treasury rates near 1.70% are not zero and 10s and 30s are even
better, but much of the Treasury yield curve now rests in negative
territory when compared with expected future inflation, and that should
send our bond investor into a hoppin’ funk. Prices are already nearing
the boiling point and his coupons are subzero, CPI adjusted. Total
return…and our frog…are cooked, or if not they are certainly trapped in a
future low return kettle of water.
of Economic Research have exposed this dilemma in more sophisticated
prose. In her second research paper, entitled “The Return of Financial
Repression,” she affirms PIMCO’s thesis of skunking, pocket-picking and
frog cooking by describing a century-old policy maneuver used by
governments facing a debt crisis. Rather than outright default, many
countries attempt rather successfully to keep nominal interest rates
lower than would otherwise prevail. Reinhart characterizes this as
“financial repression” because over the long term it results in a
transfer of wealth from savers to borrowers. Governments, having taken
on too much debt, rather stealthily lower interest rates via
central-bank-enforced policy rates or maneuvers such as “quantitative
easing.” The artificial yields, in effect, act as a tax on savings,
undercompensating asset holders and transferring the haircut benefits to
the debtor nation. Coincidentally (and certainly serendipitously),
corporate and some household balance sheets are re-equitized as the
negative or historically low real interest rates allow economic growth,
profits and some wage earners to build up a margin of safety for future expansion.
financial repression over the past century, comparing two repressive
periods (1945–1980 and 2008–2011) to a more normal interest rate
environment without artificial government yield dampeners (1981–2007).
Both periods of repression show bell-shaped curves shifted markedly to
the left, with today’s current cycle offering 2½% less yield for the
average G-7 nation than what bond investor frogs have gotten used to
since 1981. Actually, in the U.S., May’s month-end estimate for real
Treasury bill yields shown in Chart 1 would be 5% less than what Reinhart shows as the average compensation for the last 30 years!
in order to allow Uncle Sam to balance its books. Whatta we gonna do
about it? “Frogs of the world unite,” as Lenin might have said, and so
here’s where I harken back to Mark Twain and my second lesser-told frog
story. There was this other frog who instead of being tossed into a pot
of hot water was left to cool its heels in a pitcher of cold milk.
Unable to jump out, he churned and churned those frog legs until
eventually the milk turned into butter and the hardened butter allowed
him the platform to leap to froggy freedom! Well, let’s get churnin’,
fellow frogs. If the U.S. or the U.K. or any other government is going
to attempt to boil us alive, let’s make butter! Butter in this instance is what PIMCO characterizes as “cheap bonds.”
Potentially confusing, “cheap bonds” is really a simple concept – sort
of like the teeter-totter. Any bond, even a Treasury bond, is composed
of several pieces – sort of like an atom with its neutrons, electrons,
protons, positrons, neutrinos (whoops, don’t wanna go too far here).
There’s an interest rate or yield piece, commonly measured by
“duration.” There’s a credit piece, typically referred to as a “spread”
when you buy a corporate bond. And there’s a volatility piece, a
liquidity piece and other little bits and particles that will go
unexplained for now. The important point, though, is that if the
government is going to artificially repress yield, then an intelligent
frog should focus on the parts of a bond that are less repressed! You
can, for instance, produce a 1% expected return in today’s market in a
number of ways. Buy a repressed 3-year Treasury note at just under 1%,
or purchase an A-rated corporate floating rate note (FRN) with little to
no durational risk at a 3-month LIBOR +75 basis points spread,
currently returning 1%. Which is the better deal? Well, they both appear
to lead you to the same place but our cheap bonds argument would
maintain that the FRN gets you there with a lot less risk. The credit
piece, in other words, is a safer spread than the duration piece.
marvel at how PIMCO can be doing so well in 2011 while being underweight
the Treasury/durational component of the bond market. Folks – we're
making butter. If you’re being repressed, our strategy is to churn those
legs, get out of the pitcher, and above all stay away from boiling pots
of water. Recent press coverage has focused on the end of QEII and what
it may or may not do to Treasury prices. Let me reaffirm what we’ve
said for many months now. Because the QEs cover an extraordinary period
of monetary policy with a limited time frame, there is not enough data
to indicate whether the end of QEII will lead to higher or even lower
rates, although higher is our strong preference. “Who will buy them?” remains a critical question to be answered.
There is, however, overwhelming evidence – now provided by Carmen
Reinhart among others – that existing Treasury yields fail to adequately
compensate investors for the risk of holding them when measured on an
which means buying more floating and fewer fixed rate notes, adding an
additional credit component – be it investment grade, high yield,
non-agency mortgage or emerging market related – and shading your
portfolio in the direction of non-dollar emerging market currencies.
Investors shouldn’t give their money away, and at the moment, the
duration component of a bond portfolio comes close to doing just that –
not because a bear market is just around the corner come July 1, but
because it doesn’t yield enough relative to inflation. Come on frogs,
make butter, not someone else’s dinner. Buy cheap bonds!