BOND MARKET

Not many kids dream about becoming bond traders. They may dream about being James Bond, but that is as far as it goes.  Bonds are the least interesting sibling of financial markets, overshadowed by the more volatile equity family member. This is awesome because perception asymmetries create opportunities. Bonds do not look sexy but they are very powerful generators of passive income. The core of Rebel Finance is the acquisition of high-quality assets that generate a stream of long-term passive income. Bonds, therefore, cannot be ignored.

 

Bond investing and equity investing are worlds apart. Investing in equities is a game of offense. You are at the back of the line during bankruptcy proceedings. You have nothing to lose and therefore you can swing for the fences. You are looking for a stock that can double, triple or quadruple. Your upside is unlimited. Warren Buffett became a billionaire due to this uncapped nature of equity investing - the sky is the limit. The stock market elicits all the animal spirits and when the bull market is in full gallop, the testosterone turns us into savage beasts.

 

Bond investing is for people that see the glass as half full. In finance, these people work in risk, legal, and compliance departments. Their job is to police the people that are making the money. They are one step removed from the front office world of trading and five steps removed from the salaries that these traders make.  

 

You may dress in black, use dramatic makeup, Beetlejuice is your favorite movie and you listen to the Smiths. You may feel marginalized, but rest assured – the bond market welcomes you, understands you and needs you. 

 

Introduction to the Wonderful World of Bonds

 

A bond is a loan. When you buy a bond you are lending money to the issuer. Do not be fooled by all the fancy names. In the U.S., government bonds are called Treasuries, in the UK gilts, in Germany bunds, in Mexico Mbonos, in Colombia Coltes, and in Japan JGBs.  

 

When you lend money, you earn an interest rate. In the bond world, we refer to this interest rate as the coupon. In the previous century, back when dad came home from the office in a horse-drawn cart and kids actually communicated with their parents through the dying medium of spoken words, bond certificates contained a page of coupons. When the coupon date arrived, investors would physically tear the perforated lines separating the coupons and clip off the appropriate coupon. This coupon would then be presented to the issuer's payment agent and the coupon would be paid, at which time the investor would find the nearest saloon, pay for a couple of whiskeys, a woman, a room and hay for his horse.

 

A bond is also known as a fixed income instrument but that does not reveal enough. It is like the photo of Marilyn Monroe standing on top of the subway vent. It leaves you wanting to see a little more. Most bonds pay a fixed coupon but other bonds pay a floating coupon,  an inflation linked coupon or no coupon at all.

 

Four Fabulous Types of Bonds

 

Important things come in packs of four- the Four Horsemen of the Apocalypse; four Teenage Mutant Ninja Turtles; Jerry, Elaine, George and Kramer in Seinfeld; and the Fabulous Four Beatles.  In bond world, there are four types of bonds.   

 

Bond Type 1: Fixed Coupon 

According to data from Bloomberg, in 2020 half of all issued bonds in the world paid a fixed coupon.  The reason for the high demand for these issuances is duration. Fixed-rate bonds have a longer duration than variable-rate instruments. They are therefore perfect instruments for pension funds.  

 

These funds look after people retiring in 10, 20, 30 and 50 years. Their obligations are projected far out into the future. They need to invest in assets that mature far into the future. If you want to use bond trader talk, they are looking for mega long-duration investments and fixed coupon bonds do the trick.  

 

Duration is determined by the size of the fixed coupon and the length of the bond.  According to information from Bloomberg, as of 2020, 650 fixed-rate bonds matured after 2100. The longest dated bond was issued by the St Lawrence and Ottawa Railroad maturing in 2880! The University of Oxford has a bond maturing in 2117.

 

One bond that stands out like an NBA basketball player in a Tokyo subway is an issuance from the Argentine Republic.  It matures in 2117 and pays a coupon of 7 1/8 percent. Three questions need to be asked about these Argentine bonds. Question 1: who in their right mind would lend money to Argentina, a country that has defaulted eight times? Question 2: who in their right mind would lend money to Argentina for more than one week, let alone 100 years? Question 3: who in their right mind would lend Argentina money for 100 years and only require a return of 7 percent?   When this bond was issued in May 2018, it was three times oversubscribed.  The issue size was $3 billion but there was demand for $9 billion. There was demand of $9 billion for an issuance maturing in 100 years, backed by a serial defaulter, and paying a wretched coupon of 7 percent.  One can never underestimate human stupidity, especially when money is involved. Flash out a bunch of Benjamins, and IQ levels halve. Our relationship with money is similar to the male relationship with female cleavage.  

 

Bond Type 2: Variable Rate

 

Variable-rate notes are bonds where the returns are more mixed and varied than the business and extramarital affairs of Frank Sinatra. Coupons are linked to an index that is not fixed. The most common floating index is LIBOR – the London Interbank Offer Rate which has become the biggest joke in finance. In a world that has spawned jokers like Nick Leeson and Bernie Madoff, it takes a special talent to be the biggest clown.  Strap on your seat belt, because we are going on a wild ride.

 

According to the Bank of International Settlements Triennial Report issued in 2016, there were $400 trillion of financial instruments linked to LIBOR.  Let's put this number in perspective. According to the World Bank, at the end of 2018, global GDP was almost $86 trillion. This means that the notional value of LIBOR linked securities was almost five times the global economy.  

 

If that does cause you to break out in hives, consider how LIBOR is fixed every day. Market prices clear based on supply and demand. Buyers and sellers come together and prices are set based on the intersection of the demand and supply curves – this is all I learned in Economics 101. This, however, is not how LIBOR is set.  

 

It is set based on a daily survey of 17 banks.  LIBOR is calculated by the Intercontinental Exchange (ICE) and published by Refinitiv. Each day, the BBA (British Bankers Association)  surveys a panel of banks, asking the question, "At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just before 11 am?"  The BBA throws out the highest 4 and lowest 4 responses, and averages the remaining middle 9, yielding a 22% trimmed mean.  

 

The average is reported at 11:30 am. The banks are Bank of America, Bank of Tokyo-Mitsubishi UFJ, Barclays Bank, Citibank NA, Credit Agricole CIB, Credit Suisse, Deutsche Bank, HSBC, JP Morgan Chase, Lloyds Banking Group, Rabobank. Royal Bank of Canada, Société Générale, Sumitomo Mitsui Banking Corporation, Norinchukin Bank, Royal Bank of Scotland and UBS AG.

 

How difficult would it be to create a WhatsApp chat with 17 people? The answer: easier than calculating the tip on a $100 check. After the financial crisis,  it came to light that the banks were colluding to fix Libor. Numerous traders are now sitting behind bars and being forced to spoon with 400-pound brutes named Bubba or Larry.  

 

The most high profile case was against Tom Hayes, who was the first victim of the LIBOR scandal. The former Citibank and UBS employee, who was based in Tokyo, was sentenced to 14 years in prison in 2015. The jury unanimously found him guilty of eight counts of conspiracy to defraud.  

 

The Serious Fraud Office argued that Hayes was at the center of a network of traders at ten firms that conspired to manipulate the LIBOR benchmark between 2006 and 2010.  He joined Citigroup in 2009, where he earned £3.5 million in nine months before he was sacked when his methods were discovered. The court heard that he offered curry, trips to football matches and money in exchange for favorable LIBOR submissions. He offered curry?

 

Not only are bankers rotten to the core, but they can be influenced by a plate of curry to fix an index that determines the valuation of trillions of dollars of instruments.  I would have thought that would have demanded more than a curry – maybe a lobster thermidor or Beluga caviar with champagne? Bankers are a cheap date.

 

Interbank indices are the most commonly used reference on floating-rate notes. Europe uses EURIBOR, Japan uses JPY LIBOR, South Africa uses JIBAR, Mexico uses TIIE (an interbank rate that resets every 28 days based on the lunar calendar), Colombia uses IBR and Brazil uses DI. The majority of these rates are set making use of an auction where money changes hands and therefore more difficult to manipulate. 

LIBOR will be assassinated at the end of 2021 and tossed into a side-street dumpster. It will be replaced with the Overnight Financing Rate (SOFR). SOFR is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities.  SOFR is calculated as a volume-weighted median of transaction-level tri-party repo data collected from the Bank of New York Mellon (BNYM) as well as GCF Repo transaction data and data on bilateral Treasury repo transactions cleared through FICC's DVP service, which are obtained from DTCC Solutions LLC, an affiliate of the Depository Trust & Clearing Corporation.  

 

Each business day, the New York Fed publishes the SOFR on the New York Fed website at approximately 8:00 a.m., reflecting data for the prior business day.  It is going to be difficult for bankers to manipulate SOFR but you should never underestimate the creativity that germinates from lust and greed.  

 

Example of a Floating Rate Note

In 2013, Ford issued a floating rate note maturing in 2023. The reason why corporations like to issue floating notes is because of asset and liability matching. Their income (their principal asset) is variable and they like to issue debt (their liability) that will mirror this variability. The coupon on these notes was 3 month LIBOR plus a spread of 160 basis points.  

 

In the world of bonds, coupons are expressed in percentage terms and spreads are expressed in basis points. One basis point is the same as 0.01 percent. So, 160 basis points are 1.6 percent. This spread is a reflection of the credit risk of the issuer.  

 

LIBOR is effectively seen as a risk-free benchmark. It is the rate at which high-quality banks can lend and borrow between themselves. The fact that Ford is riskier than a highly rated bank is reflected in this spread. Investors demand to be paid an interest rate above LIBOR before they lend money to the automaker.  

 

Bond Type 3: Inflation Linked  

 

The coupon on these bonds is linked to inflation. Inflation is a slippery bugger.  It describes the general rise in prices. It is the silent killer because it eats away at the purchasing power of money. It is so gradual and so insignificant in the short term, that people don't pay much attention to it.  

 

The human brain and body are wired only to protect itself against clear and present danger – it is not designed to protect you from something that may kill you in 5 or 10 years.  

 

Inflation is the silent assassin and it is for this reason that investors need to focus on real returns. This is a simple equation. Real returns are the difference between nominal returns and inflation. For example, if you are earning a nominal return of 8 percent on a bond and inflation is running at 5 percent, the real return is 3 percent. This is the return adjusted for inflation.

Inflation is declining globally and has been for over a decade. During the 1970s, inflation spiked to 15 percent in the U.S. on the back of Nixon's decision to move the U.S. dollar off gold and the Yom Kippur war which saw oil prices spike to $73 per barrel.

 

Over the past forty years, there has been a secular decline in inflation and as of 2020, it was  3.2 percent. Japanese inflation hit 23 percent in the 1970s and by the mid-1980s it was negative. It has been teetering around zero ever since.  

 

In emerging markets, the trend is similar. In 1992, Russian inflation hit 250 percent. From these lofty heights, it has trended down and is now at around 5 percent. Mexico, Colombia, and Brazil in Latin America echo similar stories. The only countries that are bucking this deflationary trend are those that are in the throes of crisis – such as Venezuela, Zimbabwe and to a lesser extent Argentina.

 So what is happening?

Most of us old folks remember the 1990s. Neon, baggy jeans, lingerie as daywear, leopard print, polo shirts, bike shorts, and inflation targeting. Central banks in all countries except for Japan became obsessed with fighting inflation.  Given the Cold War was over, they needed to find another enemy and inflation was the perfect villain. At the same time war was declared on inflation, globalization took off.  Between 1990 and 2000, trade grew from 39 percent of global GDP to 51 percent. Trade borders came tumbling down and this systematic downward shift in inflation started to accelerate.  Thirty years into the war on inflation and we can declare victory. Now we face a more dangerous enemy. This enemy is deflation – inflation's evil twin. 

 What is more dangerous – inflation or deflation?

Central bankers stuck in the 1990s, who are still chasing after the windmills, will tell you inflation is the vicious beast that needs to be contained at all costs.   Fighting inflation is relatively simple. You increase interest rates. By increasing the cost of money, people and businesses spend less and this cools down the economy and lowers inflation. How do you fight deflationary price pressures? Instead of prices going up, they are heading in the other direction. That's easy, you just do the opposite. Instead of increasing interest rates, you cut them.  But there is a problem with this. Interest rates can be increased to the heavens – there is no upside limit because infinity is a concept that is impossible to understand. On the flip side, rates have a soft floor at zero.  They can go negative, but it is complicated to sustain negative interest rates because it means money has a negative cost. Effectively banks will pay you the  interest on your loan. That will never happen in practice but you can understand the distortions that this will cause. Japan now finds itself in its fourth decade of deflationary pressures. 
 

Why should you care about all of this?
You want to stay as far away from inflation bonds as you can unless you believe that there is going to be a rebound in inflation. If globalization has held down inflation, might its reversal—thanks to the trade war, Brexit and the coronavirus pandemic—send it shooting back up?    

 

Bond Type 4: Zero-Coupon Bonds

 These bonds pay no coupon. Who in their right mind would buy a bond if it pays no interest?  It happens more often than you think. Instead of buying a bond at par, let's say 100, and having a coupon paid every 6 or 12 months, a zero-coupon bond strips all the coupons out at the beginning and discounts the present value of these coupons from the price. Let’s look at a simple example. Instead of buying a 1-year bond at 100 and receiving a coupon of 6 percent, you could buy a zero-coupon bond at 94 (100 – 6) and when it matures, you will receive 100.  Most short dated government bonds are zero-coupon. You buy them at a discount and they mature at par.  This removes the administrative trouble of having to make coupon payments on an instrument that is going to expire soon. Zero-coupon bonds with longer maturities are not uncommon. The beauty of these instruments is that there is no reinvestment risk. When you buy a bond that pays a string of coupons, to earn the yield to maturity you must reinvest every coupon at the same yield to maturity over the life of the bond.  If interest rates are falling, coupons will be invested at a lower rate and that will hurt your return.  The zero-coupon bond, because it has no cash flows, does not have any reinvestment risk.