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Why All This Fuss Over Bond Yields?

Feature Stories | Mar 31 2021

It is fair to say most Australians don’t understand bond yields, or even know with certainty what a bond is. This article is a 101 lesson in what a government bond is, and why suddenly stock markets have been running away in fear of them.

-What is a bond?
-Why are bonds issued?
-What’s inflation got to do with it?
-Why are bond yields impacting stock markets?

By Greg Peel

What is an equity?

Few Australians do not know what an equity, or share, is, but to understand bonds it is best to begin with a comparison.

When you invest money in the stock market, by buying shares, you are entrusting in that company to increase the value of those shares. The end result is you might become rich, or might never see that money again.

Aside from capital gain, an investor may be looking for an income stream from dividend payments. The decision to pay dividends, and the amount of any payment, is entirely at the discretion of the company’s board. There is no obligation.

Newer companies in a growth phase will typically not pay dividends, or perhaps just token dividends, while longstanding companies tend to be reliable payers.

For some companies, dividend payments fluctuate with economic cycles. Witness Australia’s iron ore miners being the biggest dividend payers of all right now. That could well change down the track.

Equities are an open-ended investment. One can sell out at any time, or hold on for retirement. Equities do not have a maturity date.

Equity investment represents the largest allocation in any standard investment portfolio (not counting direct investment in a property). The second largest allocation typically goes to fixed income (including bonds). This is our starting point.

What is a bond?

A popular alternative to investing in equities, which come with capital risk, is to put your money away in the bank where it’s safe. Depositing money in a bank equates to lending the bank your money, for which you are paid interest. The rate you are paid on your money is at the discretion of the bank.

Bank deposits can either be open-ended, such as a savings account, for which interest rates can rise and fall over time, or have a specific maturity, as is the case with term deposits. A term deposit comes with a fixed interest rate for a fixed period.

Given Australia’s is a sound and well-regulated economy, a bank deposit is essentially “risk free”. The regulator (APRA) ensures banks are carrying sufficient amounts of capital to ride out any crises, the central bank (RBA) acts as the “lender of the last resort” to banks, and if necessary, the federal government will guarantee deposits up to a certain amount (as was the case in the GFC).

An Australian government bond is basically a term deposit, but with the government rather than a bank. Bonds have a maturity date, and pay interest, and at the end of the life of the bond you get your money back.

In buying a bond, you are lending money to the government, for which you receive interest. Australian government bonds are also considered “risk-free”, as are the government bonds of other “first world”, developed economies.

Not necessarily so in emerging or unstable countries. Argentina, for example, has a long track record of defaulting on its government bonds.

Why does the government need my money?

As Australians are more than aware, governments either run a budget deficit or budget surplus. A deficit in any one year implies the government is spending more (through welfare, defence, health, infrastructure, so on and so forth) than it is earning (primarily through taxes).

A government’s annual budget is little different to any average household budget. If you spend more than you earn in any year, the difference has to come either from savings (surplus) or through borrowing money (deficit). A household budget typically includes various debt servicing obligations, from the mortgage to the car loan to credit cards.

When the government is running a budget deficit, that deficit has to be covered. This is done by borrowing money from Australians, either from individuals, or from super funds, other funds and corporations, or from offshore investors.

To borrow money, the government issues bonds across different maturities. The “benchmark” maturity is the ten-year bond, which is indicative of an economy’s perceived health into the future, but not too distant a future.

Right now the Australian government, and virtually every government, is borrowing money hand over fist to fund rescue packages (such as JobKeeper) and economic stimulus measures (such as infrastructure) to get us safely out of the covid mess. To do this the government issues bonds.

Were covid to never have happened, the Australian budget would by now have been in a significant surplus (thanks to commodity prices), suggesting the government need not borrow any money and thus not issue any bonds.

However, governments always issue bonds, be the budget in deficit or surplus. In times of surplus, the money may not be immediately needed but it is important to maintain a “liquid” bond market in a first world economy as the “risk-free” bond rate is a benchmark for all other capital markets, and government bonds offer a safe alternative investment for all Australians via their super or other funds. Fund managers need to "roll over" bonds in their portfolios that have matured, in order to maintain that investment. To do so they need the government to continue to issue new bonds, even in times of surplus.

One might have assumed the benchmark for capital markets would be the RBA overnight cash rate and at the shorter end of things, time-wise, this is indeed the case. But Australian banks are unusual in the world in pricing, say, a 30-year mortgage rate based on the overnight interest rate.

American banks price a 30-year mortgage off the government 30-year bond rate. Apples to apples.

So how does a government bond work?

The Basics

Government bonds typically have a face value of $100. This means one can lend the government money in increments of $100, making bond investment accessible to most Australians. (Corporate bonds typically begin at $10,000, but we’ll examine corporate bonds another time).

If you buy a ten-year government bond for $100, in ten years the government will pay you back $100. Each year the government will pay you interest on that loan at a rate fixed at the time of issue (just like a term deposit).

The fixed interest rate on a bond is known as the “coupon”. For the sake of easy maths, let’s say you buy a ten-year bond with a coupon of 1%. This means as well as getting your money back in ten years, each year you’ll be given a dollar. So your net gain over ten years is $10, on top of your money back.

Whoopee, you say, but these are the unfortunate times we live in, since the GFC, not just covid. But at least you know your money is safe.

What we can deduce is that a $100 dollar ten-year bond at 1% is actually worth $110 by the time it matures.

Except for one problem.

The price of milk

That problem is inflation. We all well understand inflation – it’s why we were paying a lot less for a litre of milk, in face value terms, ten years ago, and will be paying a lot more in ten years’ time.

(This writer well remembers working in a pub as a uni student when the price of a schooner was 72c, in 1980. Now you can’t buy that same schooner for less than $7.00.)

The inflation implication is that when you get your $100 back in ten-year’s time, it’s not really worth $100. It is at face value, but not in today’s money.

And not only that, as each year goes by that $1 interest payment you’re receiving is also diminished in value in today’s money terms. That $110 in total you were coveting will gradually pay for fewer and fewer schooners over time.

The last reading of Australia’s headline CPI, for the December quarter, was an annual 0.9%. This quite simply means your 1% annual interest payment is eroded each year in “real” terms by 0.9%, so in reality your “real” interest rate is 1.0-0.9 = 0.1%.

And your original $100 will by maturity have been eroded by inflation over a full ten years.

Which begs the question, why on earth would you buy a government bond? The simple answer is if you want to keep it safe, where else can you put it?

One year term deposit? Currently you’ll get 0.1% before inflation. The stock market? Well your money’s not safe there. Investment property? If you can afford it, and be approved for a loan, but you’re not entirely safe there either.

In some countries, government bonds are currently paying negative interest rates. Well that’s plain stupid, as it implies you are paying the government to have your money. Who would do that?

The answer is many, many people, mostly pension funds, large corporations and even other governments. Because other than that money being safe, if the inflation rate is also very low, in “real” terms you can actually be ahead if positive inflation is actually lower (in absolute terms) than the negative interest rate on offer.

So if we consider all of the above, we can move on to why the ten-year bond rate has been rising recently (here and offshore) and why everyone is subsequently becoming panicked, as is evident in a volatile stock market.

Presently, every daily movement of the ten-year bond rate can either sends stocks soaring or plunging.

Pricing a Bond

Now I hope you’re sitting down, because I have to tell you something.

There is no such thing as a daily ten-year bond rate.

For there to literally be a daily ten-year rate, the government would have to be issuing new ten-year bonds every day. It doesn’t – it only does so periodically. And a ten-year bond is only a ten-year bond on the day it is issued.

The next day it is a 9-year, 364-day bond. In five years, it is a five-year bond. What you bought five years ago is still a ten-year bond, but it’s half way through its life. And you have by now received half of the interest payments due.

While government bonds can be purchased on issue, like shares they are thereafter traded in a secondary market.

A ten-year bond can change hands in the secondary market every day for ten years and, like shares, at different prices. Government bonds are listed on the ASX but are quite illiquid. To access the secondary market (or primary bond issue), a small investor is best trade through a retail bond broker which will act as market-maker (provide buy/sell prices).

Which brings us to bond prices.

To explain bond pricing I will use today’s (day and time of writing) numbers. The government ten-year is trading on a yield of 1.69%, and a price of $98.11. Face value is $100 and the coupon rate is 1.5%.

Except it doesn’t exist. Rather, these numbers are calculated to provide for an indicative yield. This is done by interpolating between the prices of already issued bonds across the “yield curve”.

If you take all yields, from the overnight cash rate, through 30-day, 90-day and one-year bank bill rates and onto three-year, five year and twenty-year government bond rates and draw a line between them, ie join the dots, you have a yield curve.

That curve can be drawn through the current trading prices of all ten-year bonds on issue, which now have 9,8,7, 6 etc years to maturity, and all the twenty-year bonds, that similarly have 19, 18…15, 14 years left, and somewhere on that line is the daily ten-years-from-now point. Using actual rates, a fictitious daily ten-year bond yield can be calculated.

(Sort of, but hang on just a moment.)

This is also used as the benchmark price for ten-year bond futures but let’s not go there at this stage.

So, back to our fictitious ten-year bond numbers above. The first thing that sticks out is the bond paying 1.5% interest is yielding 1.69%, and the bond that’s going to give $100 back in ten-years’ time, plus annual interest payments, is only worth $98.11.

It is important to note the lower the price of a bond, the higher the yield. To understand this better, consider dividends on stocks.

Every day in the paper (or in real time on today’s media), you can check what the share price of a company was yesterday/is now and what its dividend yield is. The dividend yield is useless information, as it reflects only the yield based on the last dividend payment, which might be six months ago.

More relevant is an analyst’s forecast of dividend yield for the year ahead. It may only be a forecast, thus not guaranteed, but it is more relevant than historical yield. And most importantly, that yield is calculated off the current share price, hence telling you the yield you might be able to achieve if you bought now.

If you already own the shares, your own dividend yield could be a lot different. As an example I’ll use some whacky numbers but they make it easier to grasp.

Let’s say you bought your shares at $10 last year and now they’re trading at $20. After you bought them, a $1 dividend was paid, implying a yield of 10%. The next year, a $2 dividend was paid, again implying 10%. But you bought your shares for $10, so your own yield is actually 20%.

The lower price implies a higher yield. If the shares had actually fallen to $5 and the company paid $2, your yield would be 40%! But that’s assuming a company that’s lost half its value would still pay out a full $2. It more likely would this time pay much less, or nothing.

The lesson here is to be wary of too-spectacular yields.

We can see from this example if prices are lower (your $10 entry versus today’s $20 price), then the dividend yield is higher on the lower price.

The same is true in the bond market. We know that a bond will pay the same coupon (dividend) every year, so if you buy on issue in our example, you’ll get 1.5% or $1.50 every year.

If you buy now, when the price is $98.17, the actual yield at the moment is more than 1.5%, and also incorporates the rest of the coupon payments ahead, adjusted for “real” returns, ie inflation, and the “real” value of the $100 you get back and…as is the case in all markets…demand and supply.

We know that today’s share price is a reflection not of the company’s last earnings result, and/or last dividend payment, but of  what the market forecasts the next earnings result might be, and the next dividend, and the year after that and the year after that…

It is also a reflection of how many shares are on offer. Have you ever wondered why Afterpay trades at over $100 when the much bigger Westpac trades only at $24? It’s because Westpac has a lot more shares on issue.

Similarly, the price of a bond in the secondary market will reflect how many of the same maturity the government has issued (supply), and at what maturity bond investors are looking to buy (demand). During times of budget surplus, bond issuance is scant (low supply). Right now, the Treasurer is borrowing with his ears pinned back (huge supply).

So while I said earlier the fictitious ten-year bond yield represents a mathematical interpolation, in reality the market is setting the price based on demand/supply.

The extent of government bond issuance determines the supply-side, but what determines demand, or lack thereof?

Why yields have been rising

When the covid crisis hit (and the GFC before it), central banks were very swift to cut cash rates to zero (or as good as) and then to use other tools, such as purchasing bonds themselves (QE), to effectively keep rates very low right out to 3-5 years.

So, if the central bank is a guaranteed buyer of bonds (or even just threatens to be), there is your initial demand right there.

The RBA has not to date been buying government bonds out to ten years, other than to cap any “market distortion”, which it did a little while ago when the ten-year yield shot up wildly.

But when covid hit it was not just central banks buying bonds. The sheer uncertainty the virus presented caused an investor rush into the safety of government bonds, even at near zero (or negative) rates. When a government issues bonds, it still needs someone to buy them.

But now, economies are beginning to “reopen”. Vaccines are rolling out. Forecasts for 2021 economic growth (GDP) are rising by the day. The need for the safety of keeping money in bonds is waning. Yet governments will still need to keep borrowing, to keep issuing bonds, to pay for the money they will still need to spend.

Another US$1.9trn stimulus package is now being implemented in the US. Here, we await the May budget. We know what’s ending (eg JobKeeper) but that does not signal the end of necessary government spending.

Since November, investors have been selling out of bonds. Hence bond prices fall, and bond yields rise. A lot of that money has found its way into the stock market. But recently, the symbiotic relationship between bond yields and the stock market has begun to impact.

While actual bond traders don’t talk much of inflation, more of demand/supply, stock investors here and in the US have become increasingly worried about a more rapid economic rebound out of covid than was originally perceived, leading to rising inflation, leading to bonds being of lesser value (as explained above re milk and beer).

Central banks disagree, particularly here and in the US, that there is any inflation threat that would cause them to to start easing back QE and other policies and eventually to increase cash rates. Not when there are still so many unemployed, for one. There will likely be a bit of an initial inflation spike, but it won’t last until the unemployment/underemployment rate meaningfully drops.

But the market has its own ideas, or more importantly, fears. And a market in fear is a market in which rational decisions go out the window. Sell now, ask questions later. The same is true for bonds.

But what’s it all got to do with the stock market?

I suggested above a “symbiotic relationship” between share prices and bond yields. In theory, if the stock market is rising it implies the economy is growing, or believed to be set to grow ahead.

But one reason the market turned tail one year ago from its covid nadir and shot up like a rocket is because interest rates were so low.

As is currently the case in the property market, house prices are rising because mortgage rates have never been so low. Low rates also mean businesses can borrow cheaply to invest in growth, or just keep the wolves from the door before things return to normal.

But what now has become very important is the aforementioned “risk-free” rate.

The risk-free rate is, again, an imaginary concept. The theory goes that if you invest your money in stocks you would want to be achieving at least the available risk-free rate of return because in buying stocks you are taking on risk.

As discussed earlier, a proxy for the risk-free rate is the government ten-year bond rate because it is as good as guaranteed (and Australia has an AAA credit rating).

If you buy shares you are looking to earnings and dividends in the years ahead. As discussed, those earnings will be discounted by inflation over the period. As the ten-year rate is capturing inflation expectations, in order to forecast a target price today for all those expected future earnings a discount is applied, each year, at the risk-free rate, to bring them into today’s dollars.

The higher the bond rate, the steeper the discount rate, hence the greater the discount on today’s valuation, hence the lower the share price.

Higher rates have prompted recent growth-to-value (and cyclicals) rotation in stock markets, most evident in the recent sharp pullback of the US Nasdaq.

“Value” stocks are typically the old plodders which have been beaten down during covid due to no fault of their own, and over a greater period overlooked as investments when there are far more exciting prospects in this new age.

“Cyclicals” may be old or new, but specifically trade in line with the ebbs and flows of the economy, which last year having ebbed is now beginning to flow again.

The most obvious “growth” stocks at this time are the new age “disruptors”, mostly online and/or cloud-based and doing nothing more than providing an old world service (eg BNPL) using new world software. The value that lays in these stocks, as perceived by the market, is not what they earned last year (or half) but what they are set to earn in the future.

Some may not even have made a profit yet, as they reinvest revenues for growth.

If the risk-free rate (bond yield) goes up, the discount to today’s value on future earnings becomes greater, hence valuations are lower, and hence share prices fall.

So therein lays the irony of the symbiotic relationship, and why so often recently good news has been bad.

Economy recovering? Good? Rates set to go up as a result? Bad! Somewhere in between is an equilibrium, the perfect balance of economic growth and interest rates, stock prices and dividends.

Somewhere out there lays Shangri-La. No one knows where that is. Nor is there such a thing as market equilibrium, because human emotion (and these days computer emotion) leads to market volatility, such that the market is always trying to trend towards equilibrium but passes through it, and way past it, up or down, every time.

Should I invest in bonds?

You probably already do. Most super funds run a so-called “balanced portfolio”, which is traditionally split into 60% equity investment and 40% fixed income (including bond) investment. Or 35% fixed income with 5% in cash, ready to be deployed when needed.

The reasoning behind this “balance”, appropriate for the average super investor who knows little about such matters, and is not inclined to, is it provides a spread of risk/reward. 40% of your investment is “safe”, but provides only a small return, while 60% of your money is at risk, potentially providing a large return.

The idea is that the safety of fixed income acts as a counter to the risk of equities through the economic cycles from here to retirement. When one goes up the other goes down, and vice versa, but over time the end result is favourable.

Right now, it’s not really working that well. Recently, if bond prices have fallen (yields rise), stock markets have fallen, for reasons outlined above. In other words, everything’s losing money.

Yet we live in interesting, and unprecedented, times. Forget the Spanish flu – stock markets were around then but the preserve of the rich. There was no central bank, there was no such thing as super, etc, etc. Beer was cheaper though.

So right now, bond investment does not look all that enticing, given (a) yields are still historically low and (b) stocks are not (net) going up as the balance. It will all settle down again down the track, one day. It always does, at least until the next crisis.

Government bonds, nonetheless, are still a safe haven.

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