Gordian Perspectives for February 2021

Certificates of Confiscation?

In the aftermath of the Great Recession, governments have actively depressed bond yields and inflated bond prices.  Unfortunately, most market manipulations ultimately meet a messy end.  If and when this particular manipulation goes the way of all flesh, yields will rise and bond investors will lose money.  Bonds would stop being effective investment instruments, and become “Certificates of Confiscation”.

Treasury Yields

Yields on 10-Year Treasuries are now below 1%.  BBB bond yields are at 2%.  These yields have been in decline for 40 years, giving bond investors a tremendous wind at their back.  Vanguard’s Intermediate Term Bond Fund (over 50% BBB) achieved a compounded return of 5.79% over the last 10 years.

Alas, those fixed income returns may no longer be sustainable.  The following chart gives a glimpse as to why.

Source: M2 Money Stock 


RELATED: Apocalypse Soon?  Part II

Can yields stay at these levels or go still lower?

After all, Washington has been very successful in its policy of crushing interest rates for the last 10 years.  But unless you anticipate large negative interest rate levels, downward movements won’t help long-term investors a great deal.  If executed today, a buy-and-hold strategy should only return an IRR of about 2%.  (If you question the math, please give us a call).

And while the same 2%-ish result may also obtain in a rising interest rate environment through a strategy of holding until maturity, interim portfolio valuations may suffer.  If market yields on a 2%, 10-year bond were to rise to 4% overnight, the bond would fall from 100 to 84.

Will Bond Investors Lose Money?

Unless you believe that rates won’t increase from here, there is a very high probability that bond investors will lose money.  If so, their portfolio values will have been partially confiscated by the corporate and government borrowers.

The implications may be significant:

  • For generations, bonds have been a standard complement to equities in investor portfolios. But due to the foregoing dynamics, investors are beginning to sour on bonds.  And everything else being equal, this should lead to lessened demand for fixed income instruments, pushing bond prices lower and yields up.
  • The US budget deficit has been tempered for years by the effects of low interest rates. Higher interest rates would render a continuation of the borrow-and-spend strategy problematic because of higher borrowing costs.
  • A greater interest burden will act as a drag on the economy. Inflation concerns would increase.
  • Higher interest rates will challenge the ability to have successful corporate debt reorganizations.
  • Higher interest rates and an overall economic drag would also retard equity valuations.
  • Investors need to find alternatives with returns unlinked to bond yields.

During the Clinton Administration, Treasury chief Bob Rubin notably stressed the importance of keeping the bond market stable.  Bond vigilantes will be carefully watching what steps the Biden Administration takes.  If interest rates start to move higher due to bond buyer boycotts, the Democrats’ ambitious plans may be at risk.


Commentary by Gordian Group CEO Henry Owsley