Pete Wargent blogspot

Co-founder & CEO of AllenWargent property advisory, offices in Brisbane (Riverside) & Sydney (Martin Place) - clients include hedge funds, resi funds, & private investors.

4 x finance/investment author - 'Get a Financial Grip: a simple plan for financial freedom’ (2012) rated Top 10 finance books by Money Magazine & Dymocks.

"Unfortunately so much commentary is self-serving or sensationalist. Pete Wargent shines through with his clear, sober & dispassionate analysis of the housing market, which is so valuable. Pete drills into the facts & unlocks the details that others gloss over in their rush to get a headline. On housing Pete is a must read, must follow - he is one of the better property analysts in Australia" - Stephen Koukoulas, MD of Market Economics, former Senior Economics Adviser to Prime Minister Gillard.

"Pete Wargent is one of Australia's brightest financial minds - a must-follow for articulate, accurate & in-depth analysis." - David Scutt, Business Insider, leading Australian market analyst.

"I've been investing for over 40 years & read nearly every investment book ever written yet I still learned new concepts in his books. Pete Wargent is one of Australia's finest young financial commentators." - Michael Yardney, Australia's leading property expert, Amazon #1 best-selling author.

"The most knowledgeable person on Aussie real estate markets - Pete's work is great, loads of good data and charts, the most comprehensive analyst I follow in Australia. If you follow Australia, follow Pete Wargent" - Jonathan Tepper, Variant Perception, Global Macroeconomic Research, and author of the New York Times bestsellers 'End Game' and 'Code Red'.

"Pete's daily analysis is unputdownable" - Dr. Chris Caton, Chief Economist, BT Financial.

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Monday, 28 January 2013

Will the "bond market bubble" collapse?

There’s a genuine risk that global bond prices may fall materially over the coming year or three.
It’s common to dismiss bonds as an investment as boring and inferior, particularly when stock markets are heading north. It’s often only when a bear market prevails that people recognise the protection that the stability and safety of bonds could have given them.
In fact, in today’s inter-connected age, it’s common for punters to have viewpoints on manner of investment strategies: stocks are better than bonds, gold is a more worthy investment than real estate, modern art is inferior as an investment to pork bellies.
The laughable thing is that, if you press people with even the flimsiest excuse for questioning you discover that viewpoints are rarely based on any kind of knowledge at all. They’re often merely half-baked opinions drawn from thin air. And nowhere is this truer than…the bond market!
Bill Clinton’s former adviser James Carville once said that he no longer wanted to be re-incarnated as a 0.400 hitter, and instead wanted to “come back as the bond market” because then he could “intimidate everybody”.
I’ve never understood why exactly, but when it comes to bonds as an investment asset class people seem to have some kind of mental block. They just can’t grasp it.  It’s probably related to the varied and arcane terminology used, but most people can’t seem to tell you what makes a bond price move up or down…or pretty much anything else about bonds for that matter.
Bonds as an investment
Originally used by medieval states to fund wars, a bond is a form of debt: a lending instrument which companies, local governments/agencies and governments use to raise funds from investors. They tend to suit investors who are seeking a secure and regular income stream, and also represent a reasonable strategy for diversifying risk in a portfolio.
There are three main types of bond: government, municipal and corporate. It can be a tad confusing as there are different names for government bonds depending on the length of time to maturity: Bills (<1 year), Notes (1-10 years) and Bonds (10 years+).
Company or corporate bonds tend to be viewed as somewhat riskier and thus often attract higher interest payments to compensate for the risk of default. Sometimes companies issue convertible or callable bonds which may allow the bondholder to convert the instrument into company stock depending upon the agreed terms.
Lack of growth
The main point that counts against bonds as a long-term investment is that they do not appreciate in value in the same manner as average stock prices or property prices.
If this was a book I would trump up some statistics to show that $1 invested in stocks in 1900 would be worth enough to acquire you half of the moon, whereas an equivalent $1 invested in bonds might just about get you through the Kris Kringle. But, as this is a blog post, you’ll just have to take my word for it that stocks are a superior growth asset over time.
To understand in detail why bonds can be a useful addition to your portfolio, I highly recommend reading The Intelligent Investor by Ben Graham.
Bond prices and yield
A bond is issued for, let’s say, a face value or par value of $100,000 with a 10% yield for 10 years. It will pay annual interest of $10,000 (known as the coupon – from ye olden days before this new-fangled internet thing came along, when actual coupons were attached, to be torn or clipped off for the claiming of the interest payments) on the face or par value of the bond.
The bond will continue to pay the coupon for the duration of the instrument’s life, although after the bond’s issuance it may be traded on the bond market. Note that most bonds pay the coupon every 6 months, although some might pay annually or quarterly.
After it being issued a bond’s price may move much in the way of any other traded security. You may opt to hold the bond until maturity, in which case in the absence of a default, you will get your principal back, but you may also elect to sell the bond on the open market.
This is the part that people can’t seem to grasp: if the bond price falls to $80,000, then effectively the yield increases to 12.5%. Why? Because the interest payment remains the same at $10,000 but you are receiving it on a price of $80,000 ($10,000/$80,000 = 12.5%). The par value remains unchanged at $100,000.
On the flip side, if the bond price increases to $120,000 then the yield falls to only 8.3%. The reasoning is the same - the interest is still $10,000 ($10,000/$120,000 = 8.3%). It really is that simple!
Why do bond prices move?
Yields on new bonds tend to reflect inflation expectations (as inflation erodes value) and interest rates (obviously), and also they reflect default risk. Greek government bonds or corporate junk bonds at times have paid very high yields to reflect the elevated perceived risk of default.
Government bond yields are thus vitally important for they effectively represent the creditworthiness of that country, and affect the country’s ability to raise funds cheaply. Increasing bond yields and borrowing costs can be extremely painful for a country and its budget.
Often bonds are effectively owned by the citizens of a country for they are bought by their pension funds which are compelled to buy due to the perceived low risk nature of government bonds.
There’s a slightly more advanced calculation which is known as the Yield to Maturity (YTM) which, as the name implies, calculates the total return the investor receives if…they are holding the bond until the maturity date. It is harder to calculate, but a simple enough concept.
So we’ve established that a higher price means a lower yield, and vice-versa.
If you own a bond, you want the price to go up as you’ve already locked in your interest. If you are about to buy a bond you want prices to fall so that you can secure a higher yield.
So what makes bond prices move? Mostly: interest rates.
When interest rates are increased, bond prices on the open market fall, which raises the yield of issued bonds. Newer bonds that are issued will have higher coupon to reflect the movement in interest rates.
When interest rates are lowered, bond prices in the open market increase - which lowers the yield of these issued bonds. New bonds are issued with lower coupons to reflect the movement in interest rates.
If you can grasp this then the other concepts such as redemption values, convertible bonds and the rest are a cakewalk.
Today’s bond prices and the yield curve
There’s talk today of a risk of a major bond market correction as the global outlook improves and expectation of interest rates rising increases.
Property investors may be fairly familiar with the concept of a yield curve which shows a graph of the effective yield on a range of equivalent instruments with different maturity dates. Although property investors become transfixed with the 30 day interbank cash rate, the yield curve on government bonds offers a suitable indicator for the longer term health of the economy.
If the yield curve is inverted and yields are falling as the time horizon increases then this is a fairly reliable indicator that the economy is heading towards recession. Luckily for Australia our bond yields look like this:
2 year bond yield – 2.67%
5 year bond yield – 2.85%
10 year bond yield – 3.32%
15 year bond yield – 3.67%
With US bond yields reaching record lows in 2012 (the Fed Funds rate being locked down at 0.25%) the outlook looked bleak, but there is increasingly hope that the US economy may be starting to improve.
The doomers, gloomers and whingers continue to tell us that the world is most definitely ending and that Australia faces the most appalling economic risks of the gravest nature.
Slowly but surely, however, the surveyed major economists, the bond markets and the futures markets are all beginning to disagree with them, suggesting that Australia will see a mildly weaker yet positive 2013, followed by low unemployment and stronger growth in 2014.
I wonder who’s right? Do you find the answer to that question just a tiny bit exciting? I do.