Thursday, July 26, 2012

Man Overboard

Interest rates have been falling for over 30 years.  Most investors in the market today have no understanding of what a rising rate environment feels like.  Their Pavlovian response to consistently lower rates has left many dangerously exposed to perils which they are unable to see.

Bonds are discussed in terms of yield while they trade in terms of price.  Higher prices beget lower yields.  In order for prices to rise, a buyer on the margin is needed.  For newer readers, this means there is one extra buyer at auction creating demand for the last note sold.  This keeps the price firm and causes the bonds to trade at a premium, or a lower yield.

In the late 1980's Japan experienced an impressive economic boom ending with a Nikkei high of over 40,000.  As the economy began to contract, large heavily levered banks felt increasing stress and clambered for relief in the form of central bank easing.  As the central bank purchased government debt, they softened the blow of the contraction.  Typically the effects of a hangover are in proportion to the excesses of the preceding behavior.  The Monday morning screwdriver is not a solution free of consequences.

Pension funds and traders saw this trend clearly and began to front-run the central bank's actions.  Two decades later, the Nikkei is just over 8,000 and the 10yr rate of return offered for lending Japan money is 0.75%.  As long as everyone keeps buying the debt, things are fine.  So, what is the problem?  At some point, a large buyer is going to make an economic decision that 0.75% is not adequate compensation.  

Let's take a look at the world's largest pension fund, Japan's very own GPIF.  The fund has obligations to a society in which retirees are beginning to outnumber young workers paying into the system.  Next year GPIF is slated to incur a 7.8% disbursement liability.  How can the fund manage this escalating burden of planned redemptions when nearly 65% of their assets are invested in securities yielding only a tenth of the cash need?  Also, once they have become net sellers, the price of government debt is likely to soften.  This will lower the value of their massive bond holdings and apply further pressure to their situation.

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