What's Next for Bonds?
The "balanced" portfolio approach of most traditional investment managers treats bonds as a valued constituent of their assets; but we tend to take a much dimmer view of their merits.
Bonds are, at root, mere liabilities. They are fixed claims on a varying future income. A generation ago, when another inflationary era was dawning, someone tellingly referred to them as 'Certificates of Confiscation'. Nothing much has changed since. Bonds offer no more participation in a successful business than does a thriving shopkeeper to his retail landlord. Indeed, to the extent that the firm truly prospers, the only bonus we can expect is that it may give us our money back early.
Bonds: commonplace and poorly paying
Bonds also suffer from the twin disadvantages that they can be issued almost at will, but also that the demand for them can be expanded beyond all credence. This means they have become at once both commonplace and poorly paying. So, today we see that, according to statistics compiled by the Bank for International Settlements, the pile of outstanding debt securities reported by its members totals $56 trillion dollars—an increase of $20 trillion, or 55%, in just the past four years.
This means that, for every man, woman, and child on the planet—many of whom live in the most abject poverty—there are currently $8,750 of outstanding obligations to be serviced, paid off, defaulted upon, or inflated away. Bonds are hardly scarce, by any stretch of the term.
Despite the depressed default rates and lowly downgrade statistics which our foolishly low-official rate environment have delivered, their low yields as a "conundrum." We take exception to the disingenuousness for he must know, full well, that these paltry returns are the result of the release of unprecedented amounts of liquidity (read 'dishonest money') into the system.
The speculators have profited and pushed yields so low because they have been given an implicit guarantee by the major central banks that they will remove today's extreme monetary "accommodation" only in baby-steps. The Fed says adjustments may be "measured", since "inflation expectations remain well-anchored". The European Central Bank complains at the politicians' lack of restraint. It admits there is far too much money about, but will only promise to exercise "extreme vigilance." The Bank of Japan will only move after cheating the country's long-suffering savers, by "overcoming deflation" to compound the insult of zero per-cent interest rates.
Bonds: financial speculation is rampant
Against this backdrop, borrowing short and lending long continues. After all, most large banks rely on funding such activity through their "prime brokerage" units for a good part of their profits. No one figure can capture all of the excess involved here, but we can offer two indicative pieces of dataCentral bank holdings of US dollars—either held in custody at the NY Fed, or on deposit at BIS reporting banks—rose by $300 billion in the nine short months to September 2004. This was a near 20% increase and it took this yield-suppressing stock of monetized promises to $1.85 trillion. Meanwhile, in the three years to that same end-date, BIS banks' loans to non-banks in the world's offshore centres (a rough proxy for the magnitude of hedge fund activity) more than doubled from $375 billion to $776 billion.
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Remember that each dollar borrowed here can be made to do the work of many more in buying and boosting the notional price of securities. But if you really want to let your jaws drop in wonderment, consider that the world's pile came close to $300 trillion as of the end of 2004, having doubled in size just since June 2002.
Additionally that entire astronomical sum is turned over once every quarter, so it is safe to say financial speculation runs rampant. It may, indeed, be the predominant human activity taking place on the planet today—at least in monetary terms.
In this environment, where bonds can be issued first and the credit needed to buy them created afterward, there is no discernible connection between bonds and the process of wealth creation. For this reason, the fact that we own some should not be taken as an endorsement of their overall worth, but rather as a testimony to the prevalence of over-valuation across the whole spectrum of securities. This over-valuation precludes us, for now, from holding more in the way of equities and other resource-related claims, so bonds are a fall-back. In short, from this perspective, we view them as cash-substitutes—nothing more and nothing less.
Bonds: handle with care
The other justification we have for holding bonds in the present state of affairs is that they offer convenient vehicles with which to minimize our exposure to the depreciating US dollar. It may cost us a few basis points, but to reach for this extra sliver of yield by extending their durations or through relaxing credit standards is not something we feel is in anyway compatible with our mandate to take the fewest possible risks with our shareholders' capital.
Therefore, you may be assured that, since we treat these bonds with the utmost suspicion and since we buy them only with the greatest reluctance, we only hold the very shortest maturities, and we only buy the highest grade credits.
By Sage Capital (Bermuda) Ltd
