The Sunday Times 27 August 2017
The history of markets is strewn with memorable episodes of euphoria – from stock picking shoe shine boys to day trading millionaires - which morphed into ebullience and proved (with hindsight) to be a harbinger of a pending crash. In time, the recent sale of Irish bonds by the National Treasury Management Agency (NAMA) at a negative yield may enter the same pantheon.
For the first time ever investors are lending the Irish Government money on a medium term basis with the certainty of receiving back less than their original sum in five years time. And this is a global phenomenon as Central banks’ response to the financial crisis has turned the normal rules of bond markets upside down; trillions of dollars worth of debt ($9tr according to the Financial Times) is trading at prices so high that the yield is negative.
Normally investors are paid interest when they lend a country money, however abnormally low interest rates have resulted in money being raised at extremely low and, as in the case of Ireland, at negative interest rates.
I’m running out of superlatives to describe how extraordinary this event was, particularly given the precarious financial position this country was in as recently as the current decade; it’s only six years since the yield on 2 year Irish bonds briefly topped 24%.
Equally extraordinary has been the goings on in more (financially) dubious parts of the world. In June, Argentina startled the markets by issuing $2.75bn worth of century bonds (not due to be repaid for 100 years!), with an effective yield of 8 per cent. You might have thought this would be a hard thing to sell. After all, Argentina has defaulted on its debts eight times in its 200-year history; spectacularly so in 2001 and again most recently in 2014. This for a country that doesn’t even qualify as an emerging market according to Morgan Stanley; it recently kept Argentina in the ranks of “frontier” nations, alongside Morocco and Nigeria.
As a measure of how blithe investors seem to the risks, one need look no further than the Ivory Coast. In recent months, the civil war-wracked West African nation underwent yet another military uprising. Unperturbed, investors heavily oversubscribed for the country’s recent sale of 16-year bonds with a 6.25 per cent yield.
This is the daytime television equivalent of Bobby Ewing walking out of the shower; all that went before was merely a bad dream.
Bond markets have been on a tear for over thirty years. Double-digit yields from the 1980’s seem so far removed from the current reality as to appear almost quaint. The throngs of bears calling the market a bubble are growing and the narrative is very persuasive.
Japan however provides salutary lessons for those tempted to back that view up. The so-called widow-maker trade has been the perennial early bet on rising rates and falling bond prices in Japan. Yields there have stayed lower for longer than many fund managers could stay solvent.
Trees don’t grow to the sky, and this bull market will end at some point. But it doesn’t have to end in tears. As Yale professor William Geotzmann observes “focusing attention on a few salient crashes in financial history ignores the base rate for bubbles. In simple terms, bubbles are booms that went bad but not all booms are bad.”
To be fair his analysis relates mainly to equity market bubbles which provide a much richer data set. Financial market history doesn’t help much when it comes to bond markets. But the conclusions one can draw from looking at them are weak at best.
None of the recent events in bond markets may turn out to be the proverbial canary in the coal mine presaging some market crash. And a focus on whether or not there is a bubble is likely obscuring the more relevant point about these events i.e. what they imply about the alternative uses for investors capital. Declining bond yields, being the traditional input for stock market valuation, have helped propel a near nine-year uninterrupted rise in equity markets. The rising tide having lifted many boats is making the job of asset allocation extremely difficult.
Investors searching for yield in increasingly shady areas of the market increases the potential for this to end badly.
Intelligent investment involves bearing risk when well paid to do so. Is lending your money to the Irish Government at an interest rate of -0.009% likely to be the best thing for your savings over the next 5 years? If the answer is yes, it’s an appalling vista.
Warning: Past performance is not a reliable guide to future performance.
Gary Connolly is Managing Director of iCubed, promoting better investment outcomes through a collaborative approach to investing. He can be contacted at firstname.lastname@example.org or on twitter @gconno1.