Economic Crisis

Bond market or black hole?

“Black hole” noun: A region of space having a gravitational field so intense that no matter or radiation can escape. Informal: 1. A place where money or lost items apparently disappear without trace; 2. A place of  confinement for punishment.

There are already over US$13 trillion of bonds trading at prices so high that they offer a negative return to investors. But now there’s talk that something even more mind bending could be just around the corner. The latest idea in the bond market would create a virtual black hole for money – ripping investment capital to shreds and leaving nothing in its wake.

This week I’m in south east England, staying with my parents in the house where I grew up. They bought the place in summer 1963, when mortgages were rare and houses were still affordable. I joined them, and my three sisters, in 1972.

The house is a rural, sandstone cottage with a large garden, a couple of substantial outbuildings and some lesser wood sheds. Little has changed since I’ve known it.

The oldest part of the house was built in 1759 – four modest, but solid rooms for a farm labourer and his family. Two more rooms were added in 1804. After that it was left much unchanged for 165 years until my parents extended it in the late 1960s, and installed internal plumbing.

This was a great place for a young boy to grow up. But I often forget just how noisy the countryside can be. Each morning a cockerel takes it upon himself to rouse the neighbourhood at the “crack of doom”. He is soon joined by a massive chorus of songbirds, each eager to make their mark on the new day.

Then the planes start. Here I am thinking and writing in the garden. The postman has just pulled up in a red van and handed me a bundle of post. The birds tweet incessantly, the cock continues to crow, and the plane loads of business travellers and tourists soar far overhead – seemingly in greater numbers each year.

It’s 257 years since someone decided to heave cartloads of stone from a local quarry, and pile them into the habitable form that I sit beside. What modern dwelling has a chance of lasting so long? Or even a fifth as long? In that year George Washington was married, the British captured Quebec from the French, and Arthur Guinness started producing his eponymous brew in Dublin. In England, life expectancy at birth was under 40 years.

The house has survived through thick and thin, and its inhabitants have surely experienced a great deal. Two and a half centuries is plenty of time to witness economic booms, recessions, depressions, technological advances, financial crises, political idiocies, wars.

You’d think there’s not much that’s both new and of note that could come sidling down the driveway. But listening to some of the local media commentators you’d think we’re all doomed.

Brexit! (What else?) This morning I was listening to Martin Wolf on BBC radio 4, a station that is a permanent background feature of my parents’ waking hours. Wolf is the chief economics commentator at the Financial Times. According to him you’d think the world was about to end.

He described Brexit – itself merely a change of political arrangements – as a “shock” that leaves us “staring into the abyss”. Something on a par with the 1997 Asian financial crisis, or the 2008 global banking meltdown. Oh, come on Martin. Calm down.

…the establishment has consistently preached doom and gloom at the prospect of Britain leaving the EU. They continue to talk their book – determined to undermine the country so that their thesis can be proved correct.

If you want to hear the voice of the deep establishment, you can’t go wrong listening to a big cheese from the FT babbling away on the BBC.  And the establishment has consistently preached doom and gloom at the prospect of Britain leaving the EU. They continue to talk their book – determined to undermine the country so that their thesis can be proved correct.

But the stone-built cottage is still standing, the birds are still chirping, and they’re still serving local ale at the pub just down the valley. As always. Even the sun is shining, which seems like a big improvement on pre-Brexit Britain. Surely things are looking up!

Hmm…not if you’re paying attention to that alien world known as the bond markets. We were only just getting used to the idea of more and more bonds trading at such bubbly prices that investors are guaranteed make a loss, or negative yield. But at least those investors will still get most of their money back in the end, when the bonds mature and the original loan is repaid.

Then along comes something even more bizarre. There’s increasing talk that the Japanese government could issue a zero coupon perpetual bond. Translated that means a loan that pays no interest to the lender, and where the original loan amount will never be paid back.

What?????!!!!! Come again?

Albert Edwards is a renowned investment strategist at French bank Societe Generale. Here is his take on this situation: “Maybe I’m getting old, or on the wrong medication, but I just can’t get my head around this brave new world where we lend the insolvent Japanese government our hard-earned money to receive nothing back from them, forever! We could just give it to them.”

Just think about it. Any asset is worth something if the value that can be extracted from it in future is more than the cost of owning the asset.

So a machine in a factory has value if it can be used to make things that are worth more than the cost of machine maintenance. A house can be lived in, which is surely worth something, or can be rented out for income.

What about financial investments? When you buy a stock or bond you’re buying an expected stream of future cash income. A stock pays dividends and the price is likely to increase over time (at least if you wait long enough). Buy at one price, receive your cash payments, sell at a (hopefully) higher price. You make a return.

Likewise with a bond, except most of them have a fixed maturity. Here today, gone tomorrow. In the past you bought a newly issued ten year bond for $100 that paid, say, $5 a year of interest coupons, or 5%. Ten years later the bond would mature and you got your $100 back. Your profit was 5% a year from the interest coupons, and $50 in total.

But how can a zero coupon perpetual bond have any value? You buy it, thus lending money to the government. You never, ever receive any interest income. You never, ever get your loan back. As Albert Edwards points out, you have effectively just gifted funds to the government. Surely this is money disappearing into a black hole?

How can something with zero benefit be worth more than zero? Is there some prestige value to owning Japanese government bonds that I’m too stupid to imagine?

How can something with zero benefit be worth more than zero? Is there some prestige value to owning Japanese government bonds that I’m too stupid to imagine? At least in the old days you could have used the paper certificates to start a fire. Now, in a computerised age, even that small comfort is denied.

In astronomy a black hole is thought of as infinite mass contained within a singularity – something so infinitely small that it has no physical volume. It’s a mind bending – and indeed light bending – concept.

This is where the bond market seems to be heading. It’s surely insane that a whole lot of nothing – the singularity of zero cash payments – can be given a price (or “mass”) above zero – meaning an infinite multiplier. That’s what I’d call an (ahem) “astronomical” price, if ever I saw one.

And yet, if we’re to believe what’s happening, one day soon the Japanese government – and perhaps others – will indeed be able to get something for nothing. This is truly, madly and deeply bizarre.

What next? Competent politicians that we can trust? Hmm. I’ll certainly need to check my own medication if that ever happens.

In the meantime, we’ll have to make do with watching the bond market turn into a bigger and bigger black hole. You should continue to navigate far from it, lest your savings get sucked in and obliterated.

Stay tuned OfWealthers,

Rob Marstrand

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.