There is much talk about the bond market crisis, but what does this really mean? Firstly let us discuss what the various terms associated with bonds means. A government bond is essentially a loan and when a government needs to borrow money it issues a bond and the entity buying the bond also receives an interest payment. If the coupon associated with the bond is say 3% then that is the annual interest paid.
When the demand for bonds increases the price of the bonds increases. Bond yields are the amount of return an investor will realise on a bond. These yields move inversely to the price of the bond. To illustrate this if it costs $200 to buy a bond and it pays a 2% coupon then the annual interest payment is $4. In the current economic climate the bond price is rising, due to increased demand, so if the price went up to say $300 then the interest payment will remain the same at $4 so the yield falls from 2% (4/200) to 1.33% (4/300) in this example.
This example clearly shows that the investor returns are diminishing but let us look at what that means in the actual global bond markets.
The tables below illustrate the current bond yields in Germany, Japan, UK and US.
|Germany Bund 2 Year Yield||-0.63%|
|Germany Bund 5 Year Yield||-0.51%|
|Germany Bund 10 Year Yield||-0.06%|
|Germany Bund 30 Year Yield||0.45%|
|JGB 2 Year Yield||-0.20%|
|JGB 5 Year Yield||-0.17%|
|JGB 10 Year Yield||-0.10%|
|JGB 30 Year Yield||0.34%|
|UK Gilt 2 Year Yield||0.13%|
|UK Gilt 5 Year Yield||0.19%|
|UK Gilt 10 Year Yield||0.55%|
|UK Gilt 30 Year Yield||1.31%|
From the charts above we can see a trend of negative bond yields for both Germany and Japan, except for the 30 year and whilst the yields are still positive for the UK and US, they are trending lower with the UK 2 and 5 Year gilts close to becoming negative. Negative yields means that if you lend money to a government you are essentially paying for the privilege of doing so.
What is clear is that in 2016 we have seen significant fall in bond yields and there is now approximately $13 trillion of global negative-yielding debt compared with $11 trillion before the Brexit vote. Perhaps more important is that two years ago there was virtually no negative yields. So what is causing these negative yields? In essence it is a combination of strong demand for sovereign debt, as explained in the earlier example, and negative interest rates in the likes of the European Central Bank (ECB) and the Bank of Japan (BOJ).
Increasing weak economic data is a contributory factor to these negative yields, due to the demand for bonds, but which is also used as an excuse not to raise interest rates. However the reality is that central banks are unable to raise interest rates principally due to interest rate swaps (derivatives) and what such a hike would do to sovereign debt, never mind the impact on bond markets.
The obvious answer would seem to indicate that there is a need to raise yields. However, should they rise significantly it would cause huge problems. Goldman Sachs produced a report in June stating that a 1% increase in Treasury yields could result in $1 trillion losses being incurred. Some argue that is being conservative. However, to put this in context that is significantly more than the entire losses incurred in the 2008 crisis. This is yet another reason why the Federal Reserve proposed interest rate hikes are nothing more than a pipe-dream.
What all this illustrates is that central bank policy has utterly failed and they are now caught between a rock and a hard place. The bond markets are now in total disarray as there is no room left for manoeuvre and has forced the likes of the Feds to admit they have no more “tools” at their disposal. When we factor in the reality of any potential interest rates hikes it has become a venomous cocktail which exacerbates an already insurmountable problem.