My friend, are you tired of watching interest rates go up and the stock market collapse – taking (just to start the list) your investment returns, your pension, your retirement, your mortgage, your prospects of a mortgage, your chance of inheritance, your imminent marriage/divorce, not to mention your general economic outlook and peace of mind, with it? If you’re looking for a fresher kind of masochism to replace irrational stock exuberance, take a gander at the bond market instead.
Yes, the stodgy bond market! The once staid but now zestily harrowing universe of fixed-income investments, of yield analysis and factored risk! With the stock market down more than 20 per cent this year, bonds – having themselves suffered a historic decline in value – are emerging as a whole new (old) place to possibly park money. If Canada’s economic overlords get inflation under control without crushing what’s left of the economy (a big if), bonds may shape up as a slow but steady way forward in this unpredictable, COVID-19-scarred and war-torn economy.
Or not. Because here’s one thing the bond markets and the central banks have starkly revealed of late: Postpandemic financial life is terra incognita. No one knows how long it will take to return to normal, or even what normal looks like any more. As the Bank of Canada kicks interest rates up to push inflation down in a bearish economy, a generation of bond traders – babies of 60 who’ve rarely had to sell a bond at a loss – are quietly tearing their hair out. (They’re a tightly wound crowd.) In the opaque and complex world of fixed-income investing, everything old is suddenly new again.
Frank J. Fabozzi’s Handbook of Fixed Income Securities (9th ed., $147.65 new), first published 38 years ago, is still the standard bond-trading text in business schools across the land. “Bonds are instruments of debt; the bond issuer borrows money from the bond investor,” Prof. Fabozzi declares in paragraph one of Page 1.
He lists nine basic categories of fixed-income investments, and 15 types of risk to which they are subject. (Interest rates are top of the pile.) The text, often chloroform in print, needs 1,800 pages divided into 72 chapters to describe the infinite variety of products and hedges and pledges the indebted have created over the centuries to convince others to lend them money.
But at the end of the day, that’s all a bond is, whatever shape it takes: an IOU to be paid back in full, with interest, by a certain day in the future.
The current outstanding value of all those IOUs, globally, is US$125-trillion. The bond market dwarfs all the world’s stock markets put together, which traded roughly US$61-trillion in 2019. Hundreds of billions of dollars worth of bonds are bought and sold and hedged and swapped and churned every day. Everybody talks incessantly about the stock market, is obsessed with the stock market, thinks the stock market is somehow the supreme measure of financial and economic health, because the stock market is easier to grasp and understand.
But the bond market is more important, by virtue of size alone, and more revealing of the true state of the economy. It’s also more opaque. You want to know about Apple shares? Look up the company’s public filings on the internet. You want to discover the provisions and restrictions and availability of the 30-year Bell Canada Series EU 2054 10 Per Cent Debentures? Good luck.
The character of the two classes of investments – flashy equities, stolid bonds – is reflected in the people who sell and trade them. Stockbrokers tend to be optimists: They concoct a story based on a company’s microeconomic details, its leadership, and cash flow and inventory. The potential upside in a stock is theoretically infinite, hence Tesla – a company that had a market capitalization of US$1.2-trillion last November, and is now worth only half that as CEO Elon Musk speaks openly about the risks of bankruptcy for the carmaker.
The stock market is often about personalities. Bonds are always about math. Bond people tend to be grumpy Cassandras, intellectual introverts and nerds who pore over giant pterodactylean macroeconomic factors – the interest rate, the rate of inflation, global commodity prices – to build what they will tell you is a rational model of the snares and terrors that lurk everywhere ahead.
”Bond investors and bond traders are really a pessimistic bunch,” Brian D’Costa, president of Algonquin Capital, a (small) $500-million bond fund, explained the other day. He trained as an engineer. “Because when you’re buying a bond, you already know what the maximum upside is. And so you only worry about what could go wrong.”
They don’t call it fixed-income investing for nothing. Often the best you can do with a bond is to hold it to maturity and then cash it in for your original investment plus interest. But at least you can always do that.
This is the dullness – but also the power – of bonds. Bonds embody only modest ambitions, but they always deliver. They reflect a fundamental human dilemma, the choice between what we dream of and what we’ll settle for. Bonds don’t make you rich, the old saying goes, they keep you from being poor. Maybe now, in this world, in our present global circumstances, with the glaciers melting and the refugees starving, that ought to be enough. So goes one line of contemporary financial prognostication.
The first known bond was a pile of corn, borrowed and paid back with interest. In ancient Sumer – one of humanity’s early attempts at civilization, back in the sixth century BC – all bonds carried a standard interest rate of 20 per cent. More than a millennium later, Venetian bankers devised the 5-per-cent war bond – money lent to France and England so they could wage war on one another, to be paid back in full, plus the vig.
The Italian banking system collapsed after England and France defaulted on some of those war bonds, which set off a clatter of foreclosures and bankruptcies across Europe, which was further deepened and prolonged by an outbreak of the Black Death. Does any of this sound familiar? Just this week, Russia defaulted on US$100-million in interest payments on about US$40-billion in foreign loans.
By the 18th century, the Bank of England was selling “perpetual bonds” that were passed from father to son to grandson, earning modest but stoutly guaranteed interest every year. The 20th-century financial writer and investor George Goodman (he wrote under the alias Adam Smith) noted in his book, Paper Money, that “when people believe in the currency, they save it and lend it for long periods of time, and those long periods permit still other institutions to take hold.”
The British Empire was built on bonds, for better and worse. During the hyperinflation of the 1920s in Germany, on the other hand, when Hitlerism was taking root, people wouldn’t hang on to the currency for longer than an hour. They didn’t trust it to hold its value. Bonds are a measure of trust.
The more reliable and dependable the bond issuer or underlying asset, the lower the risk and the safer the bet, the lower the yield on the bond. A second generally accepted truth of bondage declares that the longer the maturity of the bond is, the higher its yield should be – but that’s a less reliable rule. When short-term bonds pay more interest than long-term paper – the so-called and much-feared yield curve inversion – it means the bond market is unwilling to bet on the longer-term future, which usually implies a recession is approaching fast. Such inversions have occurred at least twice in the past month.
Government of Canada bonds are the safest bet in this country, followed by higher-yielding but slightly less secure provincial and municipal bonds (Ontario’s provincial bonds received an AA rating last week – almost triple A), followed by investment-grade corporate bonds, high-risk corporate bonds, and so on further and further out along the credit spectrum toward potential insolvency.
The economy grew so steadily after the Second World War, and inflation so slowly and gently, that bonds yielded only 3 per cent or 4 per cent a year, on average. The stock market returned 10 per cent and 11 per cent. But that was okay: They played off one another in diversified investment portfolios, one rising as the other fell, as the economic outlook wobbled back and forth.
In January of 1945, the Bank of Canada’s overnight lending rate (which anchors other interest rates, which are then shadowed by bond yields) was 1.5 per cent – exactly what it is today. Rates gradually increased until the 1970s, when inflation exploded, driven in part by U.S. spending on the Vietnam War. Canada’s overnight rate peaked in August of 1981 at 20.78 per cent (prime was 22.75 per cent). That was the apex of the nightmare mortgages remembered so vividly by boomers.
But it was also the start of four creamy decades of bond-market paradise.
In the 39 years from 1981 to pandemic-plagued July, 2020, when 10-year U.S. Treasury bond yields bottomed out at 0.55 per cent, interest rates fell back to earth. Falling interest rates are brilliant for bonds.
Let’s say (and this is simplifying) you buy a $100 10-year Province of Ontario bond with a 4-per-cent interest rate, or “coupon.” If interest rates then fall to 2 per cent, your bond is suddenly more valuable, because it pays more interest than new bonds. (Hence the famous dictum that makes bond markets and bond pricing so confusing and counterintuitive: When the cost of borrowing money rises, bond prices fall, and vice versa, because bonds and interest rates are inversely related.)
You can wait until your bond matures after 10 years and collect your $100 original investment (“the amount on the tin,” in bond parlance), plus your $40 in interest. Or you can sell the bond at its new higher price, be taxed at capital gains rates that are lower than those on interest income, and roll the profit into a new bond.
That profitable cycle recurred for 40 years, as rates and yields for the most part gambolled down the hill together. “Right now this year,” Robert Armstrong, the widely read U.S. financial commentator for the Financial Times, told me recently, “there are a lot of bond traders who have rarely sold a bond for a loss in their entire careers, because interest rates just helped them all the time. Down and down and down and down rates go, while bond values go up and up and up and up. And you just buy bonds and sell them and you make money. And it’s a pretty good life.”
The game got more complicated after the financial crisis took hold in 2008. Central banks used quantitative easing to keep interest rates low and improve capital flows. Despite low interest rates, sophisticated investors still made money by hedging interest rate spreads, and other delicacies of fixed-income investing. Several noted Canadian bond traders, including Mr. D’Costa, started new companies in the years after 2008 to specialize in just that kind of fixed-income finesse.
And then, six months ago, bond paradise evaporated, as the spectre of inflation loomed. Economists still don’t fully understand the causes of inflation, but the potential culprits this time include COVID-induced labour shortages, supply chain blockages, the war in Ukraine, and rising gasoline and food prices, all sloshing around in the backwash from vast government spending during the pandemic.
No one likes inflation, but bonds really hate it. Suddenly that 4-per-cent Ontario bond you own – that you could have sold when rates were dropping – is a loser compared to new bonds offered at higher rates, as the central banks raise interest rates to suppress inflation. The bond market automatically recalculates the value of your bond, so that it too now yields a new rate of (say) 6 per cent; but to do that, the bond’s price declines to $85, or 15 per cent less than you paid for it.
Do not try to think about this for too long unless you are a bond trader: Your brain may explode. But that’s the way the bond market rolls. When the bond market starts to fall like that, as it did late last fall, traders get worried in a whole new way. It feels like the foundation is cracking.
For the past six months, instead of being a careful hedge against losses in the stock markets – down more than 20 per cent so far this year – bonds have been in their own freefall. The FTSE Canada Universe Bond Index dropped 10.7 per cent in the first quarter. The Bloomberg Aggregate Bond Index was down 6.2 per cent, its worst quarterly performance since 1980. The value of the bonds in some widely held exchange-traded bond funds are down 14 per cent.
“For a bond investor,” Mr. D’Costa said, “that’s horrific.” If interest rates rise to 5 per cent, he predicts annual bond value losses of 20 per cent. “That wipes out 10 years of investment returns.” Lots of people won’t be retiring when they thought they would.
The carnage forced a lot of rethinking, including of the much-loved 60/40, equities/bonds portfolio mix. “I’m 46 years old,” Alex Evis, chief risk officer at RP Investment Advisors, a fixed-income investment firm headquartered in Toronto’s Yorkville district, told me recently. “If I go to a wealth adviser and they’re following their textbooks, and I give them 100 grand, they put 60 grand in the stock market and 40 grand in bonds or fixed income. Usually when the world gets worse, people want more safe things, so the price of bonds goes up. So if the world goes bad, my 60 per cent in stocks goes down, but my 40 per cent in bonds goes up a little bit. And I’m hedged.”
Are you still following him? “And when the world gets better, the stocks in my 60 per cent go up and the bonds go down. And over time I earn 8 per cent on my 60 and 5 per cent on my 40, and I retire happily.” Mr. Evis pauses. “What happened this year is that the year-to-date return on the U.S. 10-year note is down 14 per cent. I don’t know whether I was alive the last time that happened.”
It’s hard to exaggerate the scale of this change for financial markets, said Mr. Armstrong, the Financial Times commentator. “Who knows what rates are going to do now? Everyone has kind of been at sea. Virtually no one in the market except the very oldest people that might have to put off retirement have any experience of an environment like this.”
In the heyday of bond markets prior to 2008, Duncan Rule remembers, “The bond desks were always the noisiest desks.” At 58, Mr. Rule is now retired, but for a long time he was a rates and foreign-exchange trader at Merrill Lynch and CIBC World Markets Inc., among other shops. “They were the kings of the world.”
But on this recent afternoon in mid-June in Yorkville, the mood on the trading floor at RPIA, the fixed-income shop, is almost funereal. RPIA manages nearly $7-billion. But instead of shouting, the firm’s traders are staring in stony silence at the three and four computer screens that envelop their desks – six arrays and tables of data at a glance, everything from interest rates to bond prices to hedging strategies, with the news flickering away on mute to the side, just in case something happens to dent or swell a yield.
It’s a scene of anxious waiting, as the traders try to buck the relentless headwinds of inflation, recession and rising interest rates. “You’re on defence all the time” is how a trader of my acquaintance described the bloodletting of the past six months in the debt markets. “No one likes to be on defence every day.”
In the firm’s boardroom, RPIA’s 72-year-old chairman, Andy Pringle; its 60-year-old CEO, Richard Pilosof; and Mr. Evis, 46, are debating whether or not the Bank of Canada has the … er, courage … to raise interest rates sharply enough to tame inflation. The trio conduct an ongoing conversation on the question. A decisive jump in rates would slow growth and burden mortgages and increase unemployment (currently a mere 5.1 per cent), but might – might being the important word – also crush demand and vanquish inflation.
Sophisticated traders like Mr. Pilosof & Co. can make money for their clients no matter which way rates go. But they want inflation vanquished because rising inflation drives interest rates up, and bond prices down, which makes it much harder for bond-holders to make money.
Mr. Pilosof even looks like a bond trader: bulldog focus, contrarian manner, unchanging expression mostly devoid of visible emotion. He was a legend as a bond trader at RBC Capital Markets (Mr. Pilosof and Mr. Pringle and most of their advisory partners at RPIA are all RBC alumni), where he ran different fixed-income operations for more than two decades. Mr. Pilosof refuses to say – fixed-income traders are deathly allergic to talking about how profitable their business is – but a trader in that position could easily have averaged $3-million a year.
The conversation pongs back and forth. No one worries about interrupting anyone else. Mr. Evis believes the Bank of Canada’s plans to raise interest rates are too tepid to have any real effect on inflation.
Mr. Pilosof interrupts. “But people demand more money for what they do than they did two years ago. Why’s that?” He has a theory that the pandemic made people want more money, which may in turn be fuelling inflation. When rates dropped to near zero two years ago and it became difficult to make a return on a fixed-income investment, Mr. Pilosof believes, people piled their money into riskier assets such as crypto. That hasn’t worked out so well.
“Well,” Mr. Evis replies, “because food is more expensive …”
“No,” Mr. Pilosoff interrupts, “before food went up.”
Mr. Pringle steps in: “Bottom line is, there’s been a heck of a lot of demand, and unemployment’s as low as it’s been in a generation or more, so all of that has created a perfect storm.”
This is what bond traders talk about among themselves.
“So the debate among us,” Mr. Pilosoff says, “which is a very healthy debate, is whether the inflation rate has to go down by – call it demand destruction, or reduction of demand. Will that happen quickly enough by the time interest rates go to 4 per cent? If it doesn’t, and inflation stays stuck at 7 per cent, or whatever the number is, it becomes much more difficult to get it down. And that becomes a really scary thing.”
Mr. Pilosof has been in the bond game for nearly 40 years. He survived the financial collapse of 2008, when even major banks were teetering. But he claims the current economic crisis is the most challenging one he has ever faced.
It is true, as a long-time bondo told me recently, that fixed-income traders always look to the future, and therefore tend to catastrophize the present: “They always think the crap you’re in is worse than the crap you’ve been in.” But if Mr. Pilosof really thinks this is the worst he’s seen, be afraid of what is coming. Be very afraid.
“Are bond traders throwing themselves out of windows yet?” I asked Mr. Evis.
“No,” he said. “But we’re on the ground floor.”
For the first time in four decades, in other words, the collective genius of the bond market, the sector of the economy that always knows what’s coming, has no clear consensus on what’s coming. This is a rare occurrence.
That’s not to say there aren’t people with opinions out there in Bondville. You can call, say, Ian Pollick, managing director and global head of fixed income, currency and commodities at CIBC Capital Markets. It’s a bit like calling Albert Einstein to chat about the weather. Fixed-income folk tend to view the gritty world from 50,000 feet, where the patterns aren’t obscured by actual people.
Mr. Pollick will explain – a view shared in part just this week by US Federal Reserve chair Jerome Powell and European Central Bank president Christine Lagarde – that supply chains and the war in Ukraine aren’t the deepest causes of the current inflation. “A lot of very big forces that for the past 20 years have been driving interest rates lower are temporarily abating,” Mr. Pollick will tell you. The words will glide out of his mouth without hitch or hesitation. “And I do stress the word ‘temporary.’ For most people’s adult lives, especially in terms of how they constructed their retirement portfolios, they’ve recognized that there’s really been two very big disinflationary forces in the world.”
One of those forces is globalization. The other is automation. But the pandemic pushed globalization back into its lair, while the rise of ESG concerns – that would be your leftish environmental, social and governance issues – ”is by itself inflationary,” Mr. Pollick says. “So you have structural changes that are forcing more inflation into the system, and that is creating an upward move that makes bond yields an inefficient hedge to your equity portfolio.” In other words, you’re screwed. Thank you very much for attending the seminar.
Nor is the problem going away: Interest rates, Mr. Pollick argues, “are going to be higher than people are used to for longer than they’re used to.” The solution? The ravished bond market “is telling you policy makers need to raise interest rates very quickly to try and snuff out the type of inflation they’re not very good at. Central bankers know how to fight inflation that’s led by demand.” That would be your snivelling desire to own a new TV set etc.
“But the inflation we’re seeing is largely led by capacity constraints, and monetary policy is ill-equipped to deal with that type of inflation,” Mr. Pollick says. “So, like a Pavlovian response, the only thing that central bankers know how to do is raise interest rates and raise them aggressively. At some point, something will break. And that will bring an abrupt end to the narrative that the bond market is dead.”
Translated for mortals, that means there might be light ahead for investors, especially in bonds, if inflation is reined in. If interest rates go up, bond yields will go up with them. If rates come down again, that will be good for bond prices. And however damaging interest-rate boosts are for people who have debt, they can be a boon for savers.
There are traders, such as Mr. D’Costa, who believe the worst is over. He thinks inflation will be tamed within a year, at 2.5 per cent. Meanwhile the yield on 10-year government bonds has risen more than 40 basis points lately, recently hitting 3.63 per cent, the best rate since 2011. And “corporate bonds are now yielding 5 to 6 per cent,” Mr. D’Costa observes. “So just as people are saying, ‘I have to leave bonds,’ the bond market is a more investable long-term alternative.” Pause. “It pays to be a contrarian in the bond market.”
What will be more appealing in the recession that now seems almost inevitable: a stock promising a 5-per-cent dividend in a volatile market, or a stolid but solid senior bond of a Big Five Canadian bank that, as you read, guarantees 5 per cent a year?
Fixed-income analysts rag on the Bank of Canada and the U.S. Federal Reserve for not responding to inflation sooner, but the central banks managed to keep interest rates and inflation at bay after 2008 and through the pandemic, to the profit of many. And it’s not as if the famously predictive bond market spotted today’s inflation on the horizon in 2020, which would have been a good time to dump bonds. Every boom has its crash.
“Thinking about markets is very humbling,” Mr. Armstrong said toward the end of our conversation. Before he went into finance, he earned a PhD in philosophy. “You try to understand markets as best you can, but you are surprised every day. Any intelligent and conscientious person who spends time in markets is humbled by how complex they are and how unpredictable they are. And that’s something I like about the markets: You’re part of something that’s bigger than you. And there’s always something more to learn.”
We tell ourselves we can control the economy, that we’re its master. Bonds – the IOUs of the world’s debt, upon which most of its financial stability depends – have lately been reminding us otherwise. The boom that just ended lasted way longer than anyone predicted. Now we have to pay for it, which is partly what bonds are for. What’s the old line? Debt is the slavery of the free. Why are we so surprised, as some ancient once said, that good times turn out to be when people make debts to pay back in bad times?
If you understand that sentence, you understand the bond market.
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