Tuesday, 10 May 2011 - 20:00

 

Charts

Another Look at Bonds

In the month of April foreigners transferred a net R6 billion into the equity market and a massive R15,9 billion into the bond market. Naturally these strong net flows had a positive impact on the rand exchange rate.

The reason for the foreign interest in emerging market bonds especially is not difficult to ascertain – what is difficult is to decide just when these investments become expensive.

One of the largest fund managers in the world Pimco, which manages $1,2 trillion, mostly invested into bonds, is negative about the real yields on bonds and especially US bonds. As just one example of a fund manager searching for higher yields, they are investing into ““safe spread” alternatives available globally, including developing/emerging market debt at higher yields denominated in non-dollar currencies.”

This is not necessarily a reflection of the inherent value in local bonds, but more a case of the relative value against very expensive US and other developed market bonds.

What is the fundamental problem?

The central issue is that around the world governments have accumulated far too much debt. Total outstanding debt as a factor of GDP has escalated dramatically. In the US and the UK the same thing occurred back in the 1940’s in WWII.

According to Pimco, In order to slowly reduce this debt burden as a function of the size of the economy in the US, Treasury capped long term bond yields at 2,5%, forcing a situation of negative real yields.

As can be seen from the chart above into the 1950’s to late 1970’s debt as a function of GDP reduced from around 125% to around 40% - mostly due to negative real interest rates.

The report from Carmen Reinhart and Belen Sbrancia titled “The liquidation of Government Debt” found that in the UK and US the annual liquidation of debt due to negative real interest rates was on average 3 – 4% of GDP per year. This is how the chart above reflects a reduction in percentage terms while debt grew in absolute terms.

Negative real interest rates are nothing short of legalised theft from savers of their hard earned savings. Pimco says that by 1979 when Volcker came in as the Federal Reserve chairman and could once again start implementing real interest rates, “US (and UK) debt levels had been normalised, primarily at the expense of savers who had been “repressed” (and depressed!) for over three decades. At that historical turning point, government bonds were labelled “certificates of confiscation”. Not only had savers received Treasury bill rates that were negative for over 25% of the nearly four decades, but they were holding long-term AAA rated bonds trading at 30 to 40 cents on the dollar.”

Even if bond yields stay where they are at 3,3% and the Fed funds rate at close to 0%, “… savers and financial intermediaries are being short-changed by both of these yields and everything in between.”

In general, negative real rates of interest favour real assets as opposed to bonds. Right now locally bonds are trading at fair value, but globally they remain on the expensive side.

Kind regards,

Ian de Lange
info@seedinvestments.co.za
www.seedinvestments.co.za
021 9144 966

Tue, 10 May 2011

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