Is The Bond Bubble Bursting?

A few weeks ago, former bond king, Bill Gross, who for years ran the huge PIMCO bond fund, said that German Bunds were the “short of the century”. In other words, he believed that their price was too high, and must fall, so that selling them, ahead of the fall, was a near certain way of making money. The price of Bunds had risen so high that it seemed difficult to see how the price could rise much higher, and for the same reason, the yield on them had sunk so low that they offered no income return. Some Bunds were even being issued with negative yields, meaning that it was costing you money to own them. In the last couple of weeks, the yield on the German 10 Year Bund has risen by more than 900%! Okay, in absolute terms, for the ten year, that amounts to a move up from a 0.07% yield to a 0.63% yield, but it is the rate of change that is important.

This sharp rise in the Bund, has gone along with sharp rises in other bonds. The US 10 Year Treasury Note, has risen from around 1.60% to 2.27%, a rise of more than 30%, whilst the UK 10 Year Gilt has risen from around 1.50% to just over 2%, again a rise of around 30%. Never mind the low absolute level, imagine that your mortgage payments rose by 30%, let alone if they rose by 900%! Now, the new bond king, Jeffrey Gundlach, has made a similar call. He believes, as I do, that the secular interest cycle bottomed in 2012, and he sees great dangers with the junk bond market.

As I've argued in the past, this fact of the bottoming of the secular decline in interest rates, that began in 1982, has been hidden, over the last couple of years, because of global money flows. Money has flowed out of some emerging markets, and back into what are seen as safe havens in the US, UK and even the EU (after the ECB began to backstop peripheral economy bonds). The consequence has been higher bond prices and lower yields in those economies, combined with high yields in a range of developing economies. At the same time, money sucked into government bonds, and the bonds of large corporations, that are seen to have been backstopped, sucks money out of other areas of the economy.

That is one reason that some small and medium businesses have found difficulty in obtaining funds, but it is also why interest rates in other sectors of the market have remained high, for example credit card, and store card rates, the rates charged by pay day lenders and so on. But, as I wrote a while ago, that could only act to disguise the real movement for so long. On the one hand, money eventually begins to flow out of the developed economies, where bond prices have soared, and yields disappeared, and into those economies where bond prices have sunk, yields risen, and where currencies have fallen, leaving the potential for currency gains. Moreover, other factors are reducing the potential supply of money-capital and raising the demand, so that interest rates must be pushed higher.

Even the representatives of money-capital, like Larry Fink and Warren Buffett, seem now to recognise that you can't keep paying out interest, in dividends and bond yields, unless profits themselves increase, and profits don't rise unless you invest in new productive-capital. So, instead of profits going to finance share buybacks and other forms of financial engineering, it has to be used to buy new factories, machines, employ more workers, materials and so on. In short, the demand for money capital rises pushing interest rates higher. At the same time, its been seen that countries like Norway and Saudi Arabia that built up huge amounts of loanable money capital from surplus oil profits, saw those surplus profits slashed as the oil price fell, and they became borrowers to finance their state spending, rather than lenders. The fall in the supply of money capital also acts to push up interest rates. Hence around the globe, interest rates are rising, bond prices are falling and yields rising. Its not a bursting of the bond bubble yet, but it could be a sign that the pin is about to pierce the skin.

Bond prices and yields interrelate like this. A government, or large company seeking to borrow money issues a bond. The bonds are issued in various denominations, and each pays a fixed amount of interest called the coupon. A £1,000 bond that pays a £50 a year coupon, therefore, has a yield of 5% - £50/£1000. But, the bonds are auctioned, and traded in the financial markets. If there is strong demand for the bonds, the price may rise above this £1,000 nominal price. The higher the price of the bond, therefore, the lower the yield, because the coupon remains a fixed amount of interest of £50. If the price of the bond rises to £2,000 the yield halves to 2.5%, and vice versa.

Suppose companies need to invest more money to buy additional productive-capital. They issue more bonds to raise the money. That means that there is an increased supply of bonds in the market, which causes their price to fall. So, the yield on those bonds rises. In order to sell new bonds, the company has to offer a higher coupon, to match this higher yield on existing bonds. But, this has other consequences. If the yield on bonds rises, because bonds are safer assets than shares, this will tend to cause people to sell shares, so as to obtain this higher, but safer rate of return on bonds.

As people sell shares, to buy bonds, the price of shares will fall. But, dividends are merely a form of interest paid to money capitalists, just like the coupon paid to bondholders. The dividend yield moves in just the same way as the bond yield. The amount of money a company can pay out in dividends, just like the amount it can pay out as coupon on its bonds, depends upon the rate of profit it can obtain. If a firm has productive-capital of £1,000 and makes £100 profit on it, its rate of profit is 10%. If it borrows the £1,000 it uses to buy the productive-capital, this rate of profit limits the interest it can pay. The firm will not pay 10% in interest, because if it did, all of its £100 of profit would disappear.

If the firm pays 2% interest, it will retain £80 of profit, and pay out £20 in interest as dividends. But, although this relation to the actual productive capital determines the rate of profit, it has no necessary relation to the price of the shares of the company, and consequently upon the dividend yield. Suppose there are 1000 shares in issue with a total value of £1,000. The dividends paid are £20, giving a dividend yield of 2%. But, if as indicated above, shareholders begin to sell shares to buy bonds, the price of the shares may fall from £1 to £0.50. But, each share will continue to pay a dividend of £0.02. In that case the dividend yield will have risen from 2% to 4%.

Similarly, the firm may decide to issue additional shares to raise money-capital, rather than to issue bonds. If the company issues an additional 1000 shares, the increased supply of shares causes the price of existing shares to fall. The amount of money paid out as dividends remains the same, because it is determined by the mass and rate of profit the firm produces, determined by its productive-capital. So, again if the price of the shares falls, and the dividend remains the same, the dividend yield rises, but this means that shares are now more attractive than bonds, so people sell bonds in order to buy shares. The price of bonds then falls, causing bond yields to rise.  If the price of shares is halved, so that the total value of shares remains the same, the amount paid out in dividends remains the same in total, but the dividend per share is halved, so that the dividend yield then remains the same.

Finally, the price of land is itself determined by the rate of interest combined with the level of rents. Suppose, the annual rent on a piece of land is £200. If the average rate of interest is currently 2%, this £200 can be considered as the equivalent of the interest received on a bond, or the dividend obtained from a share. To obtain £200 interest from a bond, at 2% interest, the value of the bond would have to be £10,000. Correspondingly, therefore, this amount of rent, given interest rates of 5%, is the equivalent of the land having a price of £10,000. If rents remain the same, but the rate of interest rises to 5%, the price of the land then falls, because at 5%, the £200 rent is now capitalised to only £4,000, causing land prices to fall by 60%.

It can be seen why rising interest rates spell the death knell of property values, not just because people with mortgages find they cannot pay them, but because higher interest rates cause sharply lower capitalised land values. If the current average interest rate is 0.5%, and this doubles to even just 1%, this implies a halving of capitalised land prices, with a consequent effect on all other property prices.

This is a necessary consequence of the development of large liquid capital markets, so that money can move more or less instantaneously from bonds, to equities, to property. The small owners of property are the ones who suffer in such circumstances, because large scale owners of property do so not in the form of physical property – other than for their own large houses – but in the form of other financial assets based upon property, such as Real Estate Investment Trusts and so on. The units in these assets can be sold like shares, which only subsequently has an effect on actual property values, but the owners of physical property, which is not liquid, then find that they are tied to a rapidly devaluing asset, which they cannot sell.

Gundlach and others have pointed to a similar situation in relation to junk bonds. Like property, the junk bond market is not liquid, which means that when a sell-off begins, there are no buyers, which exacerbates the fall in prices. As I have pointed out recently, the fall in oil prices exposed the fact that 30% of junk bonds financing the energy sector were already distressed. Although oil prices have recovered from their lows, they remain at only half their previous levels, and supply continues to rise, suggesting that another fall in prices may be required to flush out excess supply. There is a strong possibility of defaults in the junk bond markets, with unknown consequences for liabilities in the CDS market.

In addition, there is the situation in Greece. Although, previous bail-outs of private banks and finance houses, shifted the risk of default from the private sector to the central banks and state institutions the risk remains. The ECB itself now possesses large amounts of sovereign bonds that may be worthless if Greece defaults, not just the Greek bonds it and other central banks holds, but the bonds of other peripheral economies it now holds, which may be worthless. The banks in the periphery have been stuffed with cash to buy the sovereign bonds of their own state, which has caused those bond prices to rise. But, the assets of those banks are based on hugely fictitious capital values for property, shares and other financial assets. A rise in interest rates, which causes share and bond prices to drop, and which sees property values crater, as indicated above, will expose the bank capital of these banks as worthless, and so the basis of the ECB's lending to them as being highly risky too – the reason the German Bundesbank has been so opposed to it from the start.

A Greek default will leave the ECB having to fill the hole in its bank capital that will be left from having to write off the Greek bonds it holds as collateral. There will be as yet unknown consequences for other central and private banks across the EU. It is what happens when you simply print money to solve a problem that is really about a lack of capital. Unfortunately, as Marx outlines in Capital Volume III, bankers have never understood the difference between money and capital, and that failing continues today.