Strategy : Bonds For Secular Stagnation
Larry Summers was definitely no sour grapes when he brought up the secular stagnation issue last Dec shortly after he pulled out of the Fed chair race and has been harping on it since.
“There is increasing concern that we may be in an era of secular stagnation in which there is insufficient investment demand to absorb all the financial savings done by households and corporations, even with interest rates so low as to risk financial bubbles.”
No Fed chairperson would like to be in charge during such times and not just because Larry Summers gets a lot, lot more money from his consulting stints with banks.
What does it mean for us ?
Let’s set the parameters for my case and you can decide later if you agree with my line of thought.
1. Junk spreads have tightened beyond comparison versus fit and proper credits.
Even loss making companies can IPO or are acquired by Yahoo, Facebook and the likes. M&A premiums that GE, Temasek and gang are paying for their acquisitions have served to encourage spread tightening of potentially dangerous names.
The latest is Bloomberg’s allegations that bond investors are buying junk bonds without the usual safeguards that they would have commanded in the past just on sheer demand that bankers can afford to be arrogant to fussy buyers. http://www.bloomberg.com/news/2014-05-23/bond-buyers-skip-fine-print-as-low-rates-sow-complacency.html
2. The central banks are caught in an interest rate and stimulus conundrum in this slow global economic recovery.
If economic conditions improve from here, the risk of stimulus withdrawal and rate hikes will threaten the recovery, which will translate to lower valuations and therefore, risk a credit meltdown.
In other words, good news may cause a corporate bond sell off.
3. There is a severe shortage of long end papers globally.
The US budget deficit is shrinking albeit slowly – less issuance of long end 30Y bonds. (And the Fed’s QE has focused on buying long term bonds.)
In Singapore, insurance companies are encouraged to match the tenor of their assets with their liabilities in the new Risk Based Capital Framework model to save on capital requirements.
This means that they have to buy suitable longer duration papers BUT NOT PERPETUALS, as perpetuals take up dollar for dollar in capital.
Pension funds in the US have also shifted to long end bonds in an effort to match funding, in line with new regulations. http://www.bloomberg.com/news/2014-05-04/can-t-find-enough-30-year-treasuries-to-buy-here-s-why.html
4. Not every company qualifies to raise long term (>10 year) bonds. Only good quality companies can meet the stringent requirements in due diligence for long term fund raising, because the cost of issuance for lower rated companies would really be unfeasible from a cost perspective.
5. Business cycles have become distended with less Boom and Bust swings. Shorter cycles have been observed into the run up of the crisis back in 2008, after which everything came under cruise control of central banks.
6 years of cruise control and we have come to this juncture – forever is looking like sluggish (until the 139 million babies born this year grow up in mostly the EM and frontier regions).
About 1/3 of the world is rioting for some reason or other (mostly inequality) and popular leaders are being elected as climate change and disease threatens us.
Thus my view is that secular stagnation is probably the best outcome for us to slug it out.
Let’s look where rates have come in the past 7 years.
Note that the curve in 2007 was roughly between 2.25% to 3.5% compared to today’s almost 0% to 3.3%.
The big gaps are between the short end rates, the 1 to 10 year tenors but the long end is relatively stable.
There is another chart that traders and astute investors look it, the forward curve chart, which is projected interest rates in the future, for instance, the 5 year interest rate in 1 year’s time is 2.18% as compared to the 5 year interest rate today at 1.61%.
The 2 main components of the future interest rate is the shape of the current curve and the absolute interest rate. With a steep curve like ours today, the future interest rates are expected to be much higher.
This is what our future interest rates looks like in 1, 2 and 5 years time.
[Note that the 1, 2 and 5 year curves are derived from the current yield curve (orange). For instance, the 5 year rate in 1 year’s time is calculated as the breakeven rate of taking a current 6 year and deducting the 1 year from it (although it is not really as simple as that in terms of computation)]
It just demonstrates that you are really better off buying a 10 year bond in 5 years time than a 15 year bond, if we want to be cheeky about how it works and the fact that a 15 year bond today is much better value than a 12 year bond (just by observing the huge gap between the 10y rate in 2y vs 5y time).
Yet the main lesson we takeaway from this is that the longer tenors tend to gravitate to the same levels.
The idea that I have been attempting to incubate in the reader and am about to put forth will probably make me the public enemy of the entire private banking world.
For private banks are profit making machines too that some of us have equity stakes in. There is a need for constant turnover in investments to remain profitable.
Long Dated Debt
I am suggesting that a sensible portfolio decision for a time of secular stagnation would be to include high quality long end >15 year papers in the books, excluding perpetuals and subordinated debt.
Because it does not matter whether there is a market crash which is good for long end bonds and good for the safe haven credits, or if the market continues to stagnate and hum along to the beat of the central banks and their Mr Sandman stimuli machine which will also cap long term interest rates. Even if inflation were to emerge to warrant rate hikes, the curve will probably flatten, lifting rates up to the 5 year mark (business cycle theory).
For the recalcitrant few left standing in the Stagflation and Hyperinflation camp, the case for a safe haven assets should hold true.
The truly saddening news is that there are not many of these bonds in SGD for us to choose from within our specifications (I managed to find about 10,000 bonds to choose from in USD and EUR). The following list is all I managed to scrounge for at least 10 years to maturity, strong government links and non cyclical industries.
And we must not forget our government bonds as well, all trading about 0.10 to 0.70% higher than they were a year ago.
Leverage and Timing
I am not venturing to suggest that folks leverage to their hilt on long end papers no matter how safe the names are because a 1% move in interest rates will hit their margin calls hard and there is every probability of that in the world of long bonds.
There is a time for everything and leverage, too, has to be timed well.
Few of the bonds above except for the SGS are available for sale in these times of great scarcity which is demonstrated by the gross injustice that Temasek should yield lower than LTA and HDB.
I personally favour SGS simply for their liquidity as it is not an OTC market and there is protective legislation for buyers to demand a price under all market conditions.
Back to the case of secular stagnation, there is obviously an inevitable risk that interest rates will have to normalise in time, slow growth or not.
The markets are heavily positioned on the long side which explains the shortage of good papers and there is still not enough to go around, in SGD, at least.
I will not be rushing out in a mad grab frenzy given that rates are trading at their lows for 2014 and EM risks abound in Asia. And experience warns that timing the purchase is the key, particularly for long dated bonds.
Recounting the bond meltdown of 2003, I remember traders and bankers all rushing to purchase the 15 year SGS for their CPF ordinary accounts at fat juicy yields of 4.5% right after the bond auction led to market panic. Their logic ? Paid more than the CPF special account’s 4%. [The bond matures in 2018 and has been holding the title of the highest premium bond on the curve at close to 113 cash price]
Another good feeling about buying long dated bonds on a positive sloping curve like ours right now ?
The yields only get lower in time when the bond rolls down towards maturity.
Secular stagnation is the latest catch phrase for us. It is no excuse, in my view, to mistake junk for gold.
We cannot help but agree with the arguments that we are in this for the long haul and quite a few folks are waiting for markets to sell off.
I have seen enough bond market sell offs happen on a whim and it pays to be patient and vigilant whilst looking out for signs.
And lastly, I will leave you guys with 2 nice photo montages I created of FOOD photos that I receive on a daily basis from my dear friends who are on eating missions.