Why Bonds Aren't Overvalued

Tyler Durden's picture

Authored by Lance Roberts via RealInvestmentAdvice.com,

Doug Kass wrote a very interesting piece this week on the bond market:

“As overvalued as I believe the U.S. stock market may be, fixed-income instruments may be even more overvalued.

 

Yesterday the 10-year note was yielding 2.21% — the lowest yield since last Nov. 11 — and the long bond’s yield is down to 2.88% after weak core consumer price index (CPI) and retail sales were released on Good Friday, when the markets were closed.

 

This decline in yield and rise in bond prices may be the last opportunity for a generation to sell fixed-income positions. Indeed, bonds may now represent the single most overvalued asset class extant.”

Before I start getting a bunch of “hate mail,” let me state that I greatly respect Doug’s opinion. In this case, however, I simply have a differing view.

Both Doug and I agree that stocks are indeed overvalued. Since investors pay a price for what they believe will be the future value of cash flows from the company, it is possible that investors can misjudge that value and pay too much. Currently, with valuations trading at the second highest level in history, it is not difficult to imagine that investors have once again overestimated the future earnings and cash flows they might receive from their invested capital.

However, bonds are a different story.

Unlike stocks, bonds have a finite value. At maturity, the principal is returned to the holder along with the final interest payment. Therefore, bond buyers are very coherent of the price they pay today, for the return they will get tomorrow. Since the future return of any bond, on the date of purchase, is calculable to the 1/100th of a cent, a bond buyer is not going to pay a price that yields a negative return in the future. (This is assuming a holding period until maturity. A negative yield might be purchased on a trading basis if benchmark rates are expected to decline further and/or in a deflationary environment.) 

Given that bonds are loans to borrowers, the interest rate of a bond, at the time of issuance, is tied to prevailing interest rate environment. In this discussion, we are primarily addressing the 10-year Treasury rate often referred to as the “risk-free” rate.

However, the price of an existing bond, traded on the secondary market, is determined by the difference between the coupon rate and the prevailing interest rate for the type of obligation being considered. The benchmark rate acts as the baseline. Let’s use a very basic example.

Bond A:

  • $1000 bond bought at 100.00 (par) with a 5% coupon and matures in 12-months.
  • At the end of 12-months Bond A matures. $1000 is returned with $50 in interest or $1050 for a 5% yield.

Benchmark Interest Rate Falls To 4%

  • What is the “fair value” of Bond A in a 4% rate environment?
  • Since the coupon of 5% cannot be changed, the price must be altered to adjust the “yield at maturity.”
  • In this case, the price of the Bond A would need to rise from $100 to $101.
  • At maturity of Bond A, the principal value of $1000 is returned along with $50 in interest to the holder.
  • Since the new owner paid $1010 for the bond, there is a loss of $10 in value ($1010 – $1000) which equates to a net return of $1000 +($50 in interest – $10 loss in principal = $40) = $1040 or a 4% yield.

Got it?

The chart below shows the 10-year Treasury yield as compared to BBB to AA Corporate Bond rates. Not surprisingly, as the credit rating declines the spreads between the “risk-free” rate and the “risk” rate increases. However, with the exception of the bond market freeze during the “financial crisis,” the ebb and flow of yields primarily track the ebb and flow of the “risk-free” benchmark rate.

Since rates are generally tied to a primary benchmark, for bonds to become overvalued the benchmark rate would have to become detached from the underlying metrics that drive the level of borrowing costs.

As I have discussed many times in the past, interest rates are a function of three primary factors: economic growth, wage growth, and inflation. The relationship can be clearly seen in the chart below.

Okay…maybe not so clearly. Let me clean this up by combining inflation, wages, and economic growth into a single composite for comparison purposes to the level of the 10-year Treasury rate.

As you can see, the level of interest rates is directly tied to the strength of economic growth and inflation. Since wage growth is what allows individuals to consume, which makes up roughly 70% of economic growth, the level of demand for borrowing is directly tied to the demand from consumption. As demand increases, businesses then demand credit for increases in capital expenditures or production. The interest rates of loans are driven by demand from borrowers. Currently, as shown below, the level of demand is consistent with the interest rates currently being charged. (Also: note the sharp drop in activity over the last several months which has been previously consistent with recessionary onsets)

Since “borrowing costs” are directly tied to the underlying economic factors that drive the NEED for credit, interest rates, and therefore bond values, can not be overvalued. Furthermore, since bonds have a finite value at maturity, there is little ability for an overvaluation in the “price paid” for a bond as compared to its future “finite value” at maturity.

As I discussed previously, the primary argument that rates must go up, is simply because rates are currently so low. That is not necessarily true. Take a look at the long-term chart of 10-year equivalent Treasury rates below. (The dashed black line is the median interest rate during the entire period.)

(Note: Notice that a period of sustained low interest rates below the long-term median, as shown in the chart above, averaged roughly 40 years during both previous periods. We are only currently 7-years into the current secular period of sub-median interest rates.)

As shown, there have been two previous periods in history that have had the necessary ingredients to support rising interest rates. The first was at the turn of the previous century as the country became more accessible via railroads and automobiles, production ramped up for World War I and America began the shift from an agricultural to industrial economy.

The second period occurred post-World War II as America became the “last man standing” as France, England, Russia, Germany, Poland, Japan and others were left devastated. It was here that America found its strongest run of economic growth in history as the “boys of war” returned home to start rebuilding the countries that they had just destroyed. But that was just the start of it as innovations leaped forward as all eyes turned toward the moon.

Today, the U.S. is no longer the manufacturing epicenter of the world.  Labor and capital flows to the lowest cost providers so that inflation is effectively exported from the U.S. and deflation can be imported. Technology and productivity gains ultimately suppress labor and wage growth rates over time and debt continues to usurp capital from productive investments and savings. The chart below shows this dynamic change which begins in 1980. A surge in consumer debt was the offset between lower rates of economic growth and incomes in order to maintain the “American lifestyle.”

The problem with most of the forecasts for the end of the bond bubble is the assumption that we are only talking about the isolated case of a shifting of asset classes between stocks and bonds.

However, the issue of rising borrowing costs spreads through the entire financial ecosystem like a virus. The rise and fall of stock prices have very little to do with the average American and their participation in the domestic economy. Interest rates are an entirely different matter.

Since interest rates affect “payments,” increases in rates quickly have negative impacts on consumption, housing, and investment which ultimately deters economic growth. 

Given the current demographic, debt, pension and valuation headwinds, the future rates of growth are going to be low over the next couple of decades. Even the Fed’s own “long run” economic growth rates currently run below 2%. Given this environment, the current level of interest rates are currently “fairly valued” based on those conclusions.

Will the “bond bull” market eventually come to an end?  Yes, eventually. However, the catalysts needed to create the type of economic growth required to drive interest rates substantially higher, as we saw prior to 1980, are simply not available today. This will likely be the case for many years to come as the Fed, and the administration, come to the inevitable conclusion that we are now caught in a “liquidity trap” along with the bulk of developed countries.

While there is little left for interest rates to fall in the current environment, there is also not a tremendous amount of room for increases. Therefore, bond investors are going to have to adopt a “trading” strategy in portfolios as rates start to go flat-line over the next decade.

Of course, you don’t have to look much further than Japan for a clear example of what I mean.

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
DogeCoin's picture

Government toliet paper can be valued at anything the government wants it to be because they can force you to buy it and they do, e.g. pension plans and insurance companies. This is a stupid article.

FringeImaginigs's picture

And just who do you think determines the price of a bond / interest rate? The government? Just exactly who and how? Unless of course you mean the Fed?  And the market? And even if "the government" controlled the market what economic factor do u think are going to drive rates either higher or lower? Can you make any arguements one way or the other? Offer something of a discussion or contrary view to the article other than claim stupidity?

wisehiney's picture

Correct.

Why would I borrow from you at 3% when I would not at 2%?

Central Bank socialist fools have hit the zero bound and finally realized that negative rates are deflationary.

So the entire financial mobster gang is trying to talk rates up.

But they have created too much of a debt burden for rates to rise.

Bonus - every time there is a military, financial, natural or political crisis, everyone flees to the "safety" of treasury bonds.

Steady interest payments and occasionally nice capital gains

 

 

Be right and sit tight.

Get paid to wait.

Oldwood's picture

So Venezuela is an outlier?

wisehiney's picture

The worlds reserve currency is the outlier.

Rainman's picture

JGB10y = 0.00 %

Bund10y = 0.24%

... " I don't expect ' normal ' rates to return in my lifetime " . ( Bernank )

NoDebt's picture

"the inevitable conclusion that we are now caught in a “liquidity trap” along with the bulk of developed countries."

I wish I had said this at least 100 times since joining ZH.  My very first post EVER on ZH might have been about this.

 

Arnold's picture

You are the liquidity trap early adopter, ND.
Pretty savvy , for an economist.

Bay of Pigs's picture

Buzzsaw99 got this right several years here at ZH.

The goldbugs thought the bond bubble and ponzi would implode. It didn't and hasn't. Not yet anyway.

hairball48's picture

Bond are being bought with "printed money", not with deferred consumption(real savings). Eventually the dollar itself collapses under the current system.

ejmoosa's picture

Not only do we not buy bonds with deferred consumption, but we have borrowed consumption from the next ten years to prop up today;s meager economy.  There is nothing to fill the voids left by that borrowed consumption either.

asteroids's picture

Correct. The "full faith and credit" collapses into a black hole of debt.

ThanksIwillHaveAnother's picture

"the price of the Bond A would need to rise from $100 to $101." Wow what a discount!  And where did this buyer come from.   Did Lance forget his morning coffee??

Regarding bonds, the game is front-run it before the bond sellers default.   Too much debt!!!

CHX13's picture

Well, it comes down to a believe of values. Fiat currency IS debt, but it's a ponzi scheme that needs to grow or else the system goes bust, which it eventually will anyway. SO... as such higher interest rates (lower bond prices) will not work as the debt burden for .Gov and just about everybody else becomes quickly unbearable. So low(er) interest rates it is, QE ad absurdum. However, in terms of real money (aurum fisicum), the ever-growing mountain of fiat money and debt should mean that in real (golden) terms, bonds are already WAY overvalued. Thus, the choice is really simple and the author can stick his valuation thesis where the sun don't shine too often. GLTA, you all be on the right side of the trade when the hammer falls.

mary mary's picture

Fiat currency is debt that the government/FED takes on and then makes other people pay off.  They pay it off by accepting the continual devaluation of their savings, as the Fiat currency decreases steadily in value.

mary mary's picture

Currently 64% in bonds.

DelusionsCrowded's picture

Its actually the catalyst needed to drive scarcity that will create inflation and move interest rates . The reality is the tech manufacturing systems are creating Super Abundance , saturation of a market is reached quickly , consumers are sated SO unless an industry has a  niche item (like Apple had) which they can restrict supply using price , then then there isn't going to be any inflation .

 

The world is reaching an end game of supply restriction due to manufacturing inadequacy . The question is : If machines make everything , how do people get 'money' to buy ?

There is now a shift going on between 'money' as a tranaction medium and 'money' as a store of wealth . I see that the only way this can be solved is by having two forms of emoney . One that is distributed for comodity items like food and another that has to be earned by interacting with the market , with a service or product .The earned money doesn't have a useby date the other is only good till the next payement . This keeps society incentivised .

 

 

Uranium Mountain's picture

If for every seller there has to be a buyer, what would happen if foreign governments get wise to the fact we're not going to pay them back  and they decide to dump 10 +;trillion dollars worth of US Treasury Bonds all at once? What if nobody wants to buy them and they want to sell them?  What would be their next move?  I guess this is why China is selling them  slowly and buying real assets such as gold.

Ink Pusher's picture

If it isn't physical bullion, it's overvalued.

No allusions, No excuses No apologies.

 

 

Consuelo's picture

 

 

"However, the catalysts needed to create the type of economic growth required to drive interest rates substantially higher, as we saw prior to 1980, are simply not available today."

 

Yes they are Lance...

The problem is, people like You see the universe as revolving around the U.S. economy, instead of observing what is happening on the geopolitical stage, right in front of your eyes, in real time.    Just keep collecting your annual $$Fees, bud...

Scrooge_McDuck's picture

The author acts as if bond prices are in a free market when they're absolutely not. Yes of course GDP, wages and inflation control bond prices because that is typically what the Fed uses to control bond prices. 

How can anybody say that bond prices are fairly valued when real rates are negative? Who's going to loan anybody money when their real return is negative to maybe breakeven? 

Since in a free market, interest rates would be reflective of the supply and demand for savings, lets see the supply of savings in America over the past 100 years. I doubt anything we see would lead someone to say we should have ~2% nominal rates to <=0% real rates. 

 

 

gcjohns1971's picture

The author has not digested that real rates are negative.

If we took CB reported rates at face value we would have no instances of financial repression in recorded history.  Regimes who inflate, try to obscure the evidence through metric redefinition.

Negative real rates, given bonds' relationship to monetary supply, has negative implications for the real economy.

turkey george palmer's picture

I think bonds have a safe haven premium that will go up and rates will fall. Then the final crisis happens when a economic shock causes huge expenditures and printing becomes excessive. More excessive than can be managed. Bonds may not collapse til a steady rise in rated hits a tripping point which almost happened recently.

Gold was heading past 1375 and it looked like inflation would surge.

 

 

 

Stuto's picture

BS, from a real historical model.