In the Long Run Long-Term Government Bonds Are Safe, But We Are a Long Time Dead
Earlier in
the year the Swiss National Bank, Switzerland’s central bank, released its
latest report. While reading the news covering the bank’s financial results, I
was surprised twice.
First, it
turned out that Switzerland’s central bank still has its stock trading on
the SIX Swiss stock exchange. Now that’s what I call Die-Hard Capitalism!
Second, I was
surprised by the reaction of many observers to the financial results reported
by the SNB. They were virtually shocked that it reported the largest loss – 132
Swiss francs (143 billion US dollars) – in its 115-year history (see Reference
1 below). Switzerland has accumulated foreign exchange reserves to the tune of
more than 1 trillion US dollars invested in foreign currencies, gold, stocks, and,
of course, various government bonds. Therefore, the fact that the bank reported
stock- and foreign exchange-related losses does not surprise anyone. However, people
are often shocked when faced with large losses resulting from investments in
“safe” government bonds.
Just ask any
pension fund or insurance company in any developed country whether
government bonds deserved their “safe-haven” status in 2022 in the context
of the most serious geopolitical crisis in the last 30 years, dramatic supply
chain disruptions, and the highest inflation rates in the last 40-50 years.
The
government bond topic is rapidly becoming politically sensitive when you see newspaper
headlines such as these: “A million older workers face new pensions
misery: Bond rout wipes a third off funds – just as retirement looms. The
retirement plans of up to a million workers lie in tatters as the recent
collapse in supposedly safe government bonds battered the value of their
pension pots.” (see Reference 2 below).
Despite the
fact that the bond market is larger than the stock market, the vast majority of
non-professionals and many professionals (!) have only a very vague
understanding of bonds and interest rates. Therefore, it would be reasonable to
recall the basics of financial theory and history.
The theory of
finance says that the purchase of bonds provides their owner with the
opportunity to become the creditor of a company, an international
institution, or a government. In other words, bonds are loans traded in the
financial markets.
The
fundamental theory of finance also says that the cost of any financial
instrument depends on the amount of cash flow you can expect to receive from
investing in it. What is the cash flow an investor can expect to receive
when he or she purchases a bond? We have already mentioned that bonds are, in
fact, market-traded loans issued to governments or companies. That is why, when
purchasing a bond, an investor can expect to receive usually fixed periodic
payments (bond coupons), as well as the principal or face amount of this bond
when it is redeemed.
Still, the
simple addition of a sequence of cash flows from different time periods is not
appropriate since “Paper money eventually returns to its intrinsic
value – zero,” as the famous French philosopher Voltaire put it. That
is why the fundamental theory of finance also asserts that the cash flows
received in the future have less real purchasing power compared to the cash
flows received today. Scientifically speaking, the value of a financial
investment depends on the discounted cash flow that the investor can expect to
receive when making this investment (see picture 1 below).
Discounting,
or value reduction, occurs by using interest rates. Interest
rates consist of three components: first, a risk-free interest rate that
reflects the time effect between consumption today and consumption in the
future. It is usually paid by the governments of the most reliable borrowing
countries; second, a market-risk premium paid by all private companies since
they carry a higher risk of not meeting their obligations when compared to
governments; third, a specific-risk premium paid by each specific company.
Since both
the amount of bond coupon payments and its principal amount, when the bond is
redeemed, are usually fixed, it can be concluded that changes in its price are
almost entirely explained by changes in the interest rate used to discount the
bond’s expected cash flows. However, these changes may occur for various
reasons. The changes may occur because there is an increase in the risk-free
interest rate delivered by the central bank fighting high inflation. There
might also be a rise in the market-risk premium due to some economic or
political upheavals, for example. Or there might be a rise in the specific-risk
premium for a particular company due to any negative events directly related to
it. Still, the general conclusion is straightforward: when interest rates
rise, bond prices usually fall, and when interest rates fall, bond prices
usually rise.
Economic
history strongly suggests that that the most important variable in the world
of finance is the PRICE OF LONG-TERM MONEY, that is long-term interest
rates. It also says that the most important variable in the world of real
economy is LABOR PRODUCTIVITY. Did you know that the growth rate of real
wages is determined by the growth rate of labor productivity? Now you can see
why the growth rate of real wages has been so slow for decades (see Picture 2
and Picture 3 below).
If we are not
sufficiently productive, then various types of financial engineering — both monetary
and fiscal — will only help us buy some time before we are forced to curb our
consumption (see Picture 4 and Picture 5 below).
Now we can
present the shortest possible course of economic and financial history of
the last 60 years:
Stage 1. From
the late 1960s to the early 1980s. Technological Slowdown and Stagflation. The
growth rate of technological progress and labor productivity started slowing
down. This led to a slowdown in the growth rate of real GDP. A loose monetary
and fiscal policy aimed at supporting the faltering economy fueled demand-pull
inflation. The gold standard was abolished. Now fiat (“paper”) money was no
longer pegged to gold. This spurred inflation even further. Negative supply
shocks (two oil crises) paved the way for shortages and cost-push inflation (“stagflation”).
Inflation was soaring, long-term interest rates were soaring, stock prices were
languishing.
Stage 2. From
the early 1980s to the early 1990s. Financialization.
The US central bank started implementing a shock therapy strategy by hiking
interest rates sharply, thereby slowing down inflation, and inevitably causing
a deep recession in the economy. To support the economy and consumption a loose
fiscal policy was initiated. Most importantly, the financial sector was
liberalized to make it easier for companies and private individuals to borrow
money. The growth rate of real GDP started to accelerate. Long-term interest rates
were falling sharply, while stock prices were rising. The growth rate of labor
productivity was still slowing down.
Stage 3. From
the mid-1990s to the mid-2000s. Globalization Unlimited. A
positive supply shock following the opening-up of China, the former Soviet
bloc, and other emerging markets. New supply chains, the outsourcing of
manufacturing facilities to poorer countries, and the global migration of labor
reduced costs and eliminated the threat of cost-push inflation. This allowed to
lower interest rates even further, thus encouraging private individuals to
borrow more to support consumption. Finally, demand-pull inflation started to
reappear. Stock and other asset prices were rallying due to rising profits,
since the demand-pull inflation for final products was far above the cost of
resources, labor, and borrowed money. The growth rate of labor productivity was
still slowing down.
Stage 4. From
the late 2000s to the late 2010s. Financial Hangover. The
declining marginal economic effect from additional private debt reached its
tipping point: more private debt could not support more consumption and higher
asset prices anymore. Asset prices started to collapse, thus undermining the
creditworthiness of private borrowers and their lenders. The governments
started to refinance the private sector through stimulus programs, while the
central banks started to refinance the governments by buying public debt and
lowering long-term interest rates to zero and below. The private sector
stabilized its debt situation but at the expense of lower consumption.
Inflation was subdued. The growth rate of real GDP was meagre. Stock prices
recovered and resumed their meteoric rise since, first, input prices
(resources, labor, and interest rates) were falling; second, the amount of available
liquidity was substantially exceeding that of investable opportunities.
Cryptos, fintech and other alternative assets were thriving for the same
reason. The growth rate of labor productivity was becoming negative in some
countries.
Stage 5. From
the late 2010s to now. A New World Order in the Making. A
protracted period of low economic growth was undermining political stability
around the world. Geopolitical and domestic tensions were visibly on the rise.
Cracks began to appear in global supply chains due to trade wars, the pandemic,
and military conflicts. This led to the resurgence of cost-push inflation (“stagflation
revisited”). The central banks started raising interest rates, while asset and
stock prices are falling significantly. It is quite probable that the growth
rate of labor productivity has become negative in most countries.
Now you
probably understand that the era of financialization required low interest
rates. Furthermore, the era of financial hangover required even lower rates. As
a result, long-term interest rates were steadily declining leading to a
legendary Great Bond Bull Run of the last 40 years.
However,
there is no such thing as miracles, particularly, in finance. That is why these
developments also meant that the likelihood of a sharp rise in inflation and
interest rates at some point in the future was extremely high too. The two
remaining uncertainties were the timing and magnitude of this almost inevitable
rise. As we now know from economic theory, a rise in interest rates implies
a fall in bond prices. Furthermore, the longer the maturity of a bond is, the
more it is exposed to a rise of long-term interest rates.
Thus, before
investing in long-term government bonds, remember the following:
1.
In
terms of credit risk long-term government bonds are safe if they are
issued in the national currency of an issuing country.
2.
Since long-term government bonds may
have maturities of 10, 30, 50 or even 100 years, in terms of interest rate
risk, currency risk, liquidity risk, and inflation risk, they may be as risky
as other assets (!).
3.
In terms of interest rate risk
long-term government bonds are safe only if their periodic coupon payments are
floating. This means that the floating coupons are periodically adjusted to
reflect changes in short-term interest rates. In most cases, however, periodic
coupon payments are fixed. Therefore, a rise in long-term interest rates has a negative
impact on the price of such fixed-rate bonds. That is why in 2022 the prices
of long-term government bonds issued by developed countries fell sharply in
unison with stock prices (see Picture 6 below).
4.
In terms of currency risk if
you purchase a government bond denominated in a foreign currency for the
issuing country, then its credit risk is higher than the credit risk of an identical
bond denominated in the national currency of that country. Currency risk
also arises if you purchase a government bond denominated in a currency other
than your base currency. For example, US investors who held unhedged euro-denominated
German government bonds during 2022 suffered losses not only resulting from a
fall in bond prices, but also from a fall in the euro exchange rate versus the
US dollar. At the same time, Turkish investors gained from a rise in the euro
exchange rate against the Turkish lira (see Picture 7 below).
5.
In terms of liquidity risk illiquid
issues of government bonds may have a price disadvantage compared with identical
liquid issues. For example, investors may demand an illiquidity premium for
government bond issues that are small in terms of size. If you need to sell
such a paper urgently, you may find out that its bid price is reduced by the
amount of this illiquidity premium.
6.
In terms of inflation risk
even floating-rate government bonds do not guarantee that their prices will adjust
to fully reflect changes in the rate of inflation (see Picture 8 below). For
example, the monthly inflation rate in the United States in 2022 peaked at 9.1%,
while the 6-month US dollar LIBOR did not exceed 5.25%. In the eurozone the monthly
inflation rate peaked at 10.6% in 2022, while the 6-month EURIBOR interest rate
did not exceed 2.8%. Investing in government inflation-linked bonds whose
coupons are regularly adjusted to reflect changes in the rate of inflation may
help you hedge against consumer price rises to a greater degree. Though in a
low inflation environment they may demonstrate a significant price underperformance
too (see Picture 9 below).
John Maynard
Keynes, one of the most famous economists of the 20th century, as
well as a successful investor and speculator, once said that “in the long
run we are all dead.” To paraphrase him slightly, I would say that when
investing in bonds remember that in the long run long-term government bonds are
safe, but we are a long time dead.
References:
1.
“SNB $143 Billion Record Loss Costs
Swiss Usual Payout”, Bastian Benrath, Bloomberg, 9 January 2023.
2.
“A Million Older Workers Face New Pensions
Misery: Bond Rout Wipes a Third Off Funds – Just as Retirement Looms”, Patrick
Tooher, This Is Money.co.uk, 31 December 2022.
