Focus on... Government Bonds
Posted by jdavis on June 30, 2016
This month I'm going to Focus On... Government Bonds.
In the Booms and Busts Report, I describe what Government Bonds are.
What I didn't say is that the global market for Government Bonds is easily at least 5 times the size of the equity market. Yet, you never hear it mentioned. The news bulletins mention the Dow 30 (Why, I do not know - it's such an anachronism), the FTSE and the Pound against the Euro, normally.
Well, if the News wanted to to be helpful it would actually highlight the price of Bonds and, simultaneously, the relevant interest rate ie the rates at which governments borrow.
You see, as interest rates rise, Bond prices fall and vice versa. If you would like a fuller explanation just ask me and I'll deliver.
As you know, interest rates have been falling for decades. Thus, Bond prices have risen for decades. The following illustrate this.
30 year US Treasury rate
35 years ago the US Government was paying nearly 15% pa to borrow over 30 year periods. Thus, clever (or lucky) investors (lenders) were paid 14.5% pa interest for 30 years, till 2011, say, and then received the principal back. When you lend to the US Government, you, in effect, buy US Treasuries (USTs). In the UK Government Bonds are called Gilts.
There is a fund which you can invest in that handles it all. This is how it performed:
30 Year US Treasuries
The black and red is the moving price of 30 year USTs. So, as well as receiving c 14% pa interest - WHILE INTEREST RATES WERE FALLING AND FALLING - investors also saw the price of their investment rise from c $45 to c $135, over the 30 years. None too shabby.
The green line is US share prices. They've ultimately produced the same return but with much lower interest/dividends and with much higher volatility. Also, it seems to us they are now going to crash, whereas USTs are going to soar.
And look, in the last few years, as the mainstream media and fund managers continuously tell us interest rates are 'just about to' rise, they have in fact plummeted from 4.0% (Jan 2014) to c 2.3% today. Investors in January 2014 have received c 4.0% interest AS WELL AS capital gains of c 30% ($130 to $170). In two and a half years.
The question is what's going to happen now?
Well, you see that lending to the US today, over 30 years, gives around 2.3% pa interest (and the money back in 30 years). [Incidentally, just because you have invested in a 30 year loan does not hold you to the asset for 30 years. You can sell it any time.]
Well, lending to
UK gives 1.7% pa
Germany gives just 0.5% pa
Japan gives 0.14% pa (yes you read right!)
Switzerland gives -0.06% pa (yes minus!)
Now, if you are an investor, searching for high interest, if you can get 2.3% in the US or 0.5% in Germany, why would you go to Germany? (or Japan or Switzerland?).
That's the first reason why US rates are likely heading lower.
The second is very simple. If German rates are 0.5%, why aren't US rates at that level? In my view, there is no reason why they won't be. Thus they will head lower.
Thirdly, why do rates fall?
Because lenders are prepared to accept lower and lower rates of interest as THEY BELIEVE INFLATION WILL FALL OR EVEN WE GO TO DEFLATION.
Please see my commentary in The Big Picture, on the Chinese Yuan. China is exporting DEFLATION to the West. Thus we have the third reason why rates will go lower.
What happens to bond prices when rates fall? They rise.
Irrespective of short term volatility, we can expect US Treasury prices to continue rising - materially - for some time to come.
Also, we expect the US Dollar to rise for some time to come. So, for Sterling-based investors, this should be a double whammy.
How much long term US Treasuries have you got in your portfolio?