Author Topic: Explain bonds(markets) to me  (Read 1886 times)

Jurgis

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Re: Explain bonds(markets) to me
« Reply #10 on: August 08, 2019, 10:59:13 AM »
I'm not aware of many (any?) fund managers buying negative yielding debt. It's all institutions that have non-economic motivations (central banks, banks for regulatory reasons, etc).

A notable instance of economically minded investors owning negative interest rate debt is anyone who owns an international bond index fund.

https://investor.vanguard.com/mutual-funds/profile/overview/vtabx

For example, VTABX has an SEC yield of 0.45%, a maturity of 9.7 years, and duration of around 9 ish as well, that's because it owns a bunch of JGB's, bunds, etc. So there's an example of $130 billion of folks retirement money that is investing in this stuff.

So.... the bond itself "should" yield close to (actually less than) nothing. But when I (as a random person with no financial skill) look at my pension-savings, I see that this presumably super-safe investment is up 10% in a year. Is that part of the "bubble"-factor here?


Let's say you have bond priced at 100 yielding 1%.
Let's say you believe that this bond should be priced to yield 0.5% based on similar assets/whatever.
What would be the price of the bond based on your expected yield assuming perpetual bond for simplicity?

Yes, 200.

What is the yield difference of such bond when the price goes from 180 to 190 (up approximately 5+%)?

Yield at 180 is 0.55%
Yield at 190 is 0.526%

So for yield drop of 0.025%, the bond price goes up 5%.

You can call it bubble or whatever, but that's the math. Clearly the math also applies in the other direction (what should be the price of the bond that currently is priced at 200 and yields 0.5% if you believe it should yield 1%? Yeah, 100.)


It gets more complicated for non-perpetual bonds, but I hope you got the picture.  8)
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perulv

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Re: Explain bonds(markets) to me
« Reply #11 on: August 08, 2019, 12:37:06 PM »
Let's say you have bond priced at 100 yielding 1%.
Let's say you believe that this bond should be priced to yield 0.5% based on similar assets/whatever.
What would be the price of the bond based on your expected yield assuming perpetual bond for simplicity?

Yes, 200.


First of all: thanks for taking the time to explain this.

Intuitively, this made no sense to me. Why should an instrument with half the "payout" be worth twice as much? But I guess I'm confusing the terms yield, coupon rate, and perhaps discount rate.

I guess this would be similar to, or is in fact the same, as lowering the discount-rate in a present-value calculation? with a small enough discount-rate, the present value would be arbitrary large. I would probably be foolish to use that number to do any investing, though...

But what is the definition of "a bond yielding 1%" here? Is the calculation: a $100 bond with a coupon rate of 1%, priced at $200, is priced to be yielding 0.5%? That kind of sounds like saying "I value this stock at twice <whatever price>, because I believe the p/e multiple should be twice as high". Which I guess is the same, since half the current discount-price means twice the price current price.

Still... stocks can grow into their valuation (the e can increase), while the coupon rate cannot. Even if I get the math here (and please correct me on the above ramblings if not), not sure I get the sanity of it.

Jurgis

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Re: Explain bonds(markets) to me
« Reply #12 on: August 08, 2019, 01:47:29 PM »
Let's say you have bond priced at 100 yielding 1%.
Let's say you believe that this bond should be priced to yield 0.5% based on similar assets/whatever.
What would be the price of the bond based on your expected yield assuming perpetual bond for simplicity?

Yes, 200.


First of all: thanks for taking the time to explain this.

Intuitively, this made no sense to me. Why should an instrument with half the "payout" be worth twice as much? But I guess I'm confusing the terms yield, coupon rate, and perhaps discount rate.

I guess this would be similar to, or is in fact the same, as lowering the discount-rate in a present-value calculation? with a small enough discount-rate, the present value would be arbitrary large. I would probably be foolish to use that number to do any investing, though...

But what is the definition of "a bond yielding 1%" here? Is the calculation: a $100 bond with a coupon rate of 1%, priced at $200, is priced to be yielding 0.5%? That kind of sounds like saying "I value this stock at twice <whatever price>, because I believe the p/e multiple should be twice as high". Which I guess is the same, since half the current discount-price means twice the price current price.

Still... stocks can grow into their valuation (the e can increase), while the coupon rate cannot. Even if I get the math here (and please correct me on the above ramblings if not), not sure I get the sanity of it.

I'm not saying it's sane, but there might be reasons why it's not completely insane either.

thepupil gave some examples of why someone buys even negative yielding debt. Presumably if there's a choice of buying negative yielding debt and the debt yielding 0.5%, the buyer would buy the latter one (all else being equal of course - this is simplified example). All else being equal, you're likely to put money into a bank that pays you 0.1% rather than bank that pays you 0.01% even if neither 0.1% nor 0.01% are meaningful in terms of returns.

Finally, assuming you knew that rates will go down to 0.25% in the future, you'd probably buy the bond that yielded 1% yesterday driving its price up 2x to 0.5% yield today.
You might say "this is insane". But people who did it at 7% are laughing all the way to the bank. Then the people who did it at 4% are laughing all the way to the bank. And even people who did it at 2% are right so far. At some point the buyers will be wrong. But I doubt you or people on CoBF really know when this will happen and how.

Still not saying this is very sane, but is it completely insane? I'll let others argue for and against.  8)

Here's Bloomberg's argument of why this might be sane:

https://www.bloomberg.com/news/articles/2019-08-08/the-non-weirdness-of-negative-interest-rates?srnd=businessweek-v2
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perulv

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Re: Explain bonds(markets) to me
« Reply #13 on: August 08, 2019, 02:18:17 PM »
I'm not saying it's sane, but there might be reasons why it's not completely insane either.

thepupil gave some examples of why someone buys even negative yielding debt. Presumably if there's a choice of buying negative yielding debt and the debt yielding 0.5%, the buyer would buy the latter one (all else being equal of course - this is simplified example). All else being equal, you're likely to put money into a bank that pays you 0.1% rather than bank that pays you 0.01% even if neither 0.1% nor 0.01% are meaningful in terms of returns.


Sure, this makes sense. "I have all this money, I can't very well put it in the madras. So even if I have to pay for someone to store it safely, I'll do it. And btw, I think the rate will get more negative, so I'll lock in this "profit" at this rate". That is just a conservative investment, like a person using a high interest rate instead of a mutual/index-fund for savings. Nothing "bubbly" about that, just lost opportunities.

But that reasoning only makes sense as long as the price for the bond is close to the par value, right? If I do the above reasoning, and put my money in a bond priced at $200 with a par value of $100, my downside is (at least) 50%, and I am far into the more speculative area you describe in your second paragraph:

Finally, assuming you knew that rates will go down to 0.25% in the future, you'd probably buy the bond that yielded 1% yesterday driving its price up 2x to 0.5% yield today.
You might say "this is insane". But people who did it at 7% are laughing all the way to the bank. Then the people who did it at 4% are laughing all the way to the bank. And even people who did it at 2% are right so far. At some point the buyers will be wrong. But I doubt you or people on CoBF really know when this will happen and how.

Still not saying this is very sane, but is it completely insane? I'll let others argue for and against.  8)

Here's Bloomberg's argument of why this might be sane:

https://www.bloomberg.com/news/articles/2019-08-08/the-non-weirdness-of-negative-interest-rates?srnd=businessweek-v2


The fascinating thing to me is that it seems the first part (conservative placement of money) can sorta drift into the second. The bank that is bound by law to invest its reserves in some types of bonds, or the conservative and dull fund that my mother thinks acts like a savings-account (yielding a small but steady return), is suddenly becoming a speculation with significant downside.

(it got a bit tiresome to put in all the "I guess"-es, so even if the above is written as facts, Im still very much inquiring open for insights :))

Jurgis

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Re: Explain bonds(markets) to me
« Reply #14 on: August 08, 2019, 03:08:32 PM »
But that reasoning only makes sense as long as the price for the bond is close to the par value, right? If I do the above reasoning, and put my money in a bond priced at $200 with a par value of $100, my downside is (at least) 50%

Right.

Just remember that even if you buy bond at par value, your downside can be 50% or more if either you won't keep the bond to maturity or it defaults or inflation destroys your terminal value.

But sure, buying at 2x par adds to risk. I just omitted that since return calculations become more complex.
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cherzeca

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Re: Explain bonds(markets) to me
« Reply #15 on: August 08, 2019, 03:14:49 PM »
aren't most negative yield instruments European sovereign?  isn't the ECB saying that it will buy this debt at this price to avoid another Euro credit crunch? isn't this preferable to the Germans than having a common credit EU bond (Greece issue same bond as Germany)...which is where some in the EU were going last time of the EU crisis?

RuleNumberOne

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Re: Explain bonds(markets) to me
« Reply #16 on: August 08, 2019, 07:33:40 PM »
https://www.investopedia.com/terms/y/yieldtomaturity.asp

The above link has what you need. There are two things you get when you buy at 191:

1. The haircut of 91 when you get back the face value of 100 euros a 100 years from now.

2. The coupon of say 2 euros per year.

These are discounted back using the "yield-to-maturity". This yield-to-maturity has turned negative for upto 30-year debt. The longer the maturity the greater room for speculation.

Italy issued 50-year bonds.

Yes, it is absolutely batshit crazy. Negative yielding bonds (in a currency which likely wont exist 100 years from now) and negative yielding stocks (like WeWork) are preferred over dividend-paying stocks like WFC.

Cigarbutt

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Re: Explain bonds(markets) to me
« Reply #17 on: August 09, 2019, 06:20:33 AM »
Additional comments (are investors putting cash in negative-yielding debt stupid or prescient?):

Historically, especially if you have to match long-term liabilities and have to think long term, the total return from bonds has come from income (coupon) and not capital appreciation. Many people have looked at this and it seems that it is reasonable to assume that, under normal circumstances and even during a period of declining interest rates such as happened since the early 80's, more than 90% of the return has come from income. Here's a typical reference:
https://www.brandes.com/docs/default-source/brandes-institute/2015/income-as-the-source-of-long-term-returns.pdf

So, there are exceptions and individual decisions about what bond to buy/sell and when matter but, typically, the main driver of future returns for bonds is the starting yield. So, what are these investors thinking when the starting yield is negative? Apart form the expectations about low or lower inflation levels, there are instances when the bond investor expects that the capital appreciation component of total return will continue to occur, as has been the case recently, even in a negative interest world. Another possibility is for bond investors to benefit from "rolling down" maturing bonds in certain sloping environments. Japan provides an interesting example (at least up until recently):
https://blog.pimco.com/en/2016/04/a-surprising-experience-with-bond-returns/?_ga=2.87817880.1417941211.1565353948-1114108504.1525365177,2.87817880.1417941211.1565353948-1114108504.1525365177
But financial asset japanization is a contained disease. Right?

What terrifies me (from the investing point of view :) ), is not that these negative-rate bond investors are stupid, it is that they may be correct.

Concerning cherzeca's comment about the financial sustainability of the union, I always thought that one of the underpillars of the Maastricht Treaty was that completing successfully the project required fiscal consolidation. At least, that's what Mr. Soros has maintained for so long. Is he just an old crying wolf?
« Last Edit: August 09, 2019, 06:23:50 AM by Cigarbutt »

mcliu

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Re: Explain bonds(markets) to me
« Reply #18 on: August 09, 2019, 06:46:16 AM »
Cigarbutt's post makes sense. The conventional wisdom is that when you buy a negative-yielding bond (pay a big premium to par), your return will be negative. That's only true if you hold to maturity. In the meantime, with the ECB/BOJ buying ever more and more bonds, there's opportunity to flip bonds to them for a positive return. (Which is probably the intended effect.)

In essence, the central banks are bailing out bank shareholders by inflating asset values instead of doing a restructuring/capital-injection like in the US/UK.

cherzeca

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Re: Explain bonds(markets) to me
« Reply #19 on: August 09, 2019, 06:57:00 AM »
"one of the underpillars of the Maastricht Treaty was that completing successfully the project required fiscal consolidation."

this in my view will never happen, because Germany will not permit it. from Germany's (virulent anti-inflation) point of view, stagnation and receession are preferable