Where Does The Money Go? - Part 1

Over the last few weeks, interest rates have spiked sharply higher once more. The yield on the 10 Year German Bund has risen from 0.07% to 0.90%, a rise of more than 1000%; the yields on the 10 Year US Treasury and the UK 10 year Gilt, have both risen by around 50%; the yields on a range of European Bonds have risen similarly. Yields on bonds rise, when the prices of bonds fall, and the prices of bonds fall, when people sell them. On CNBC, this morning, a viewer asked the question, “Where does the money go to, when people sell these bonds?” The following is by way of an answer to that question.

The first answer is that there are any number of other assets which the money could be used to buy, such as land or shares, or things such as gold, silver, diamonds, art, wine, which are bought speculatively, in the hope that their value will appreciate. On the other hand, the money could be simply spent buying commodities for consumption, or stuck in the bank.

Suppose, someone has £1 million in UK 10 Year Gilts. The coupon, that is the fixed amount of interest paid on the bonds, is £100,000 so that the yield is 10%. Now, suppose that on a piece of land, currently costing £1 million, the annual rental income is £150,000. That means a yield of 15%. In that case, the owners of Gilts may well decide to sell them, and use the money to buy land, which would give them a 50% higher yield. They sell bonds, and buy land, which causes the price of bonds to fall, and the price of land to rise. When the price of bonds falls to £800,000, the £100,000 coupon on these bonds will represent a yield of 12.5%. Similarly, when the price of land rises to £1.2 million, the £150,000 of rent will also represent a yield of 12.5%.

At that point, there is no incentive for anyone to sell bonds to buy land, or to sell land to buy bonds. In essence, rents rose, possibly because economic activity increased, and the demand for land rose. As rents rose, the yield on land rose relative to bond yields, people sold bonds and bought land, so the price of bonds fell, and the price of land rose, causing interest rates to rise.

Its for this reason, also that when interest rates rise, the price of land falls, provided rents remain the same. If a piece of land costing £1 million pays £100,000 in rent, this is a yield of 10%. If a £1 million bond, now pays a coupon of £150,000, this is a 15% yield. Money would come out from selling land, causing land prices to fall, and go in to bonds, causing bond prices to rise. Now, land prices would have to fall by 20% from £1 million to £800,000, giving a yield of 12.5%, whilst bond prices would have to rise by 20%, to £1.2 million to represent a 12.5% yield.

But, the same thing applies to shares. Suppose, on average £1 million invested in the stock market brings dividends of £100,000, so the dividend yield is 10%. If the yield on bonds is 15%, then people would sell shares, causing share prices to fall, and buy bonds, causing bond prices to rise. As share prices fell, by 20%, the dividend yield would rise to 12.5%, and as bond prices rose by 20%, the bond yield would fall to 12.5%.

In reality, this relation is slightly more complicated. If money is invested in UK Gilts, its assumed that there is no risk that owners of these bonds will not be paid back, i.e. the UK government will not default on these bonds. So, whatever yield is obtained on the bonds is “risk free”. But, an investment in shares is not risk free, because companies go bust all the time. So, the yield on shares would always be expected to be higher than the yield on bonds. It would approximately have to be equal to this “risk free return” on bonds, plus a risk adjusted return.

Once again, in practice, although the UK government is not likely to default on its bonds, buyers of these bonds may still lose some of their money. If I pay £1 million for a bond, then, if over its 10 year life, there has been 20% inflation, the £1 million I get back, will actually only be worth £800,000. The government would, in reality have defaulted on 20% of the value of the bond. So, the higher expected inflation, the higher the yield I will expect on the bond. This is why, the yield on longer dated bonds is usually higher than on shorter dated bonds, because over a longer period of time, there is a greater danger of inflation, and in any case, the capital value of the bond will have been eroded.

This is called the yield curve, so that if the maturity of bonds is set along the horizontal axis in from 6 months to 30 years, and the yield is measured on the vertical axis, the curve should slope up to the right. If this curve inverts, so that it shows lower yields for longer dated bonds, this is a sign that a recession is on the way; it means that investors anticipate a period of slower growth, and lower prices.

This movement from one asset class to another in search of the higher yield, is called rotation. For some time now, as bond prices have risen to levels not seen in more than 200 years, and yields have fallen to near zero, there has been anticipation by financial analysts that there would be a “great rotation”, whereby money would stream out of these overpriced bonds, and into shares, causing the prices of the former to drop sharply, and of the latter to rise. The problem is that over the last 30 years, the prices of all assets have risen astronomically, so any sell off in bonds, does not so easily translate into a rotation into already overpriced shares, or land, or even into the asset classes that have become overpriced as a consequence of such speculation, such as art, wine, gold, diamonds and so on.

That leaves the possibility of the money coming out of these bonds going into the purchase of actual commodities. But, although the rich have shown a capacity to spend in extremely extravagant proportions, the money tied up in these various assets is so vast, that it is not possible for the rich to just spend it on more conspicuous consumption. That leaves, expenditure of the money on other types of commodities. In other words, commodities intended not for consumption, but for production. A use of the money not as revenue, but as capital.

I will examine that option in Part 2.