Dust and Echoes – Bonds 3 years ago and now

They say history doesn’t repeat, but it sure does rhyme.  Or to put it another way, you rarely see the exact same scenario repeat itself but there certainly are some which are very similar.

To some extent I feel like that with bonds at the moment.  I wrote an explainer about them quite recently given that they don’t get much love in the Aussie FIRE community, but the below post is actually something that I wrote for work about bonds and market conditions a bit over 3 years ag.

It definitely feels as if I could have written it today though and it would have turned out pretty close to the same.  I’ve updated a couple of charts and prices, but otherwise this is what I wrote 3 years ago.  The point of the post is not so much what I think about market conditions because I’m wrong about these things all the time, but moreso not just assuming that bonds are safe.

Quick disclaimer:  As is always the case you should not plan your finances around what some random person on the internet says. Everything which is written here is of a general nature at most and is certainly not specific professional advice for you and you should not be relying on it when making decisions. Whilst every endeavour is made to provide accurate information at the time of writing you should be talking to a licensed professional about any specific areas of your investments, finances, taxes etc.  Also, it’s going to be really embarrassing if it all goes per shaped and you have to explain that it did so because you read about something from a random blogger. 

Moving on, and without further ado, here’s my thoughts on bonds from 3 years ago, and also today.

I’ve talked to a few people recently about what’s been happening with bonds and whether or not we can still think of them as being a “safe” investment.  Bonds have had a great performance in the last few years, but much of that has been due to bond price appreciation from falling yields rather than the usual boring business of clipping coupons.  Looking at the performance of overseas sovereigns they have had a great 2016, as per the graph in this article   (http://www.wsj.com/articles/buying-longer-bonds-holds-danger-1469661392).

The vast majority of this performance is attributable to the huge duration in these bonds which magnifies the gains from changes in yields.  Looking at changes in the last year on Bloomberg (http://www.bloomberg.com/markets/rates-bonds) you can see that there has been huge tightening in 10yr yields almost without exception.   The flip side of this is of course that when/if yields widen, that duration is going to hurt on the downside.   

As per the below graph from Blackrock about 35% of developed market govt bonds globally now have negative yields with another 40% or so with yields in the 0-1% area and roughly another 10% with yields in the 1-2% range. (The old chart didn’t save correctly but this new one from 2019 actually does a great job of showing that we’re in a very similar position in many respects.)

There have been two main reasons for yields tightening, number one being central bank buying of government bonds (see Europe and Japan) and investors piling into “risk free” assets, ie government bonds as part of the risk off trade.  So although this has made for a good time for bond investors in the last few years, it’s hard to see a scenario where that ends well for bond investors over the next 10 years or so if rates or inflation go up as will presumably happen sooner or later.

This is due to the inverse relationship between bond prices and bond yields.  As yields go up (widen) bond prices go down, and due to the high duration in most government bonds that made them perform so well on the upside they are going to be just as sensitive on the way down (not quite due to convexity and reduced duration between when they went up and when they come down, but close enough for the purposes of this discussion) which means those big gains can fairly quickly turn into big losses.

The argument I sometimes hear against this is that so long as investors get their money back then it’s not a major worry.  The problem with this is that for bonds where they have a larger coupon than their yield (ie most Aussie govt bonds) their price is actually above their redemption price anyway.  

If you buy an Aussie 10yr govt bond at the moment you are paying around 121 for a bond that will pay you back 100 in 10 yrs time, with 10 yrs of 4.25% coupons along the way.  *The 2019 verion of this is a 10 year bond with a 2.75% coupon trading at 116.11.  So you’re not getting your full amount of money back at maturity no matter what, and any rate rises in the meantime are going to make that bond price even lower.

This means that if rates do stay low for the 10yr period then investors are getting a lousy 1.87% return (now 1.06% in 2019!) and are guaranteed to get back less in principal than what they put in.  Obviously if rates go lower then they make some money on mark to market or if they sell, but it’s hard to see rates going massively lower in Australia at least. And on the downside, if rates rise then again they have a big mark to market or real loss if they sell.  

This affects not just actual bond funds and ETFs but also other sectors and investments that are sensitive to bond rates, in particular utilities and infrastructure.

With all this in mind it’s important to be careful when thinking about bonds being defensive in nature, because with any rise in rates those defensive assets are going to lose a lot of value very quickly, in particular those with long durations which tend to be the “safer” government bonds. 

Do you invest in bonds, and do you think of them as being a safe investment?  If you enjoyed this post and would like to read more like it then please subscribe!