Today, the bond market is dominated by bondholders who are not particularly interested in maximizing their portfolios. Moreover, central banks, according to analysts, are the key reason for the appearance of such a situation on the market.
After the crisis, they launched a quantitative easing program (QE), that is, they expanded their balance by creating new money to buy assets. The total balance of the six most active securities (the Fed, the Bank of Japan, the ECB, the National Bank of Switzerland, the Bank of England and the People’s Bank of China) increased from about $ 3 trillion in 2002 to more than $ 18 trillion this year, Pimco says.
These central banks want a lower bond yield. So, the Bank of Japan plans to keep the yield of 10-year Japanese bonds in the region of 0%. Instead of acting as a vigilante, closely following prodigal politicians, central banks, in fact, become their accomplices.
In addition, there are pension funds and insurance companies on the market that buy government bonds to meet their long-term obligations. None of the groups is interested in selling bonds in case of a decrease in yield; in reality, they may have to buy more, because if there is a low interest rate, the present value of their discounted future liabilities increases.
Banks also play an important role. They are forced to buy government bonds as a “liquidity reserve” in order to avoid the problem of financing both during the 2008 crisis. Banks also use securities as collateral for short-term borrowing.
If there are so many forced buyers, state bonds are trillions of dollars traded with negative returns.
“When there are so many price insensitive buyers, the market value role of price determination is no longer working,” says Société Générale strategist Keith Jax.
Much of the twentieth century, bonds were the optimal asset for investors who wanted to have a good income. But today it is not so. Government bonds are now a place for reserve money by institutional investors.
Regulators call government bonds safe, and therefore mandatory assets for purchase.
“It’s all about the cost of capital, not the return on capital,” says Joachim Fels, chief economist at Pimco.
If central banks are interested buyers of an asset, then this asset is as good for most investors as cash. As a result, as a cash, government bonds generate a very low return, the British magazine The Economist notes.
This new form of the debt market creates problems for those who manage mutual funds or manage private capital (that is, for those who have profit as their primary goal). A significant part of the bond market no longer offers that level of profit, as in the past.
As soon as the new year begins, the polls show the confidence of fund managers in the growth of bond yields and a drop in prices; but every year they are very surprised when the yield remains low. “When your old pricing model does not work, how else can you determine when the asset is cheap?” – asks the strategist Keith Jax.
In reality, these investors are forced to take risks for the sake of getting a higher return. They buy corporate bonds, emerging market debt, as well as government bonds with longer maturities and higher yields.
The main measure of risk is the maturity or the number of years that the investor needs to return his money. In Europe, since 2008, the average length of government debt has increased from six to seven years, says Salman Ahmed of Lombard Odier.
Reducing liquidity is another problem for the bond market, which only exacerbates the problem. In recent years, there have been several sharp jumps in profitability – for example, panic in financial markets in 2013, triggered by the Fed’s announcement of a gradual curtailment of the quantitative easing program and a sharp surge in German bond yields in 2015.
According to Jak, the bond market today is “extremely fragile”. It has prices that are suitable for a world with slow growth and low inflation and there is no room for error if the situation changes dramatically. The risk that has to go is the most frightening thing in the modern debt market.