Thought Bubbles from the Deep

[Value Hunter]

I think certain institutional investors (perhaps pension funds, insurance companies, charitable organizations or banks, etc) are buying these negative yielding bonds are perhaps doing so because their hands are tied in various ways.

Perhaps their mandates dictate they must hold a certain percentage of government bonds or that they must hold debt above a certain level credit rating. Also they may need something highly liquid due to the huge sums of money involved, hence the buying of German Bunds or Japanese Government Bonds. Perhaps they prefer this to U.S. government debt which has a positive yield because they don't want the U.S. dollar exposure and its expensive to hedge (or they don't want the long-term counter-party risk). I don't know I am just speculating here. It is my gut feeling that institutions buying these negative yielding bonds are not buying it because its a good investment (obviously). Also it would be interesting to know how much of these bonds are being bought/monetized by central banks?

 

[DeepState]

I think certain institutional investors (perhaps pension funds, insurance companies, charitable organizations or banks, etc) are buying these negative yielding bonds are perhaps doing so because their hands are tied in various ways.

Perhaps their mandates dictate they must hold a certain percentage of government bonds or that they must hold debt above a certain level credit rating. Also they may need something highly liquid due to the huge sums of money involved, hence the buying of German Bunds or Japanese Government Bonds. Perhaps they prefer this to U.S. government debt which has a positive yield because they don't want the U.S. dollar exposure and its expensive to hedge (or they don't want the long-term counter-party risk). I don't know I am just speculating here. It is my gut feeling that institutions buying these negative yielding bonds are not buying it because its a good investment (obviously). Also it would be interesting to know how much of these bonds are being bought/monetized by central banks?

Asset-liability matching: when an entity like a life insurer or pension fund has liabilities which are cashflows yet to occur, these are estimated and discounted by actuaries. As interest rates decline, the value of these liabilities increases in a present value sense. To the extent that there is a mismatch between the interest rate sensitivity of the assets and the liabilities, the surplus position of these entities comes under increasing stress as yields fall. As their solvency becomes increasingly threatened they have to move to match the assets and liabilities more accurately...by buying bonds as they become ever more expensive...making them more expensive. To that end, their hands are somewhat bound and considerations move away from buying cheap assets to hedging out risk that can't be borne.

Banks are big holders. Particularly in the case of Europe and Japan, their profitability is being eroded by lower net interest margins available from maturity transformation. This is supposed to encourage them to lend. However, the weak capital position of many European banks does not really allow them to do so. Bit of a bind there. But UK banks are different.

The SNB does not hold much Swiss Bonds on its balance sheet. Less than 1% of the SNB assets are held in CHF Bonds. CHF is held in the foreign reserves of other central banks. Maybe there has been rebalancing away from other currencies into CHF bonds? You can find these things if you are motivated.

The BoJ will, by contrast, own virtually all of the available JGBs if they keep up the rate of purchases for another decade. I think they own around 20% of issuance at the moment.

 

[CanOz]

Deepstate, should we all go out and buy bonds and gold? Seems a no brainer, must a be a crowded trade by now though?

 

[kid hustlr]

That was great Can.

 

[Value Hunter]

As interest rates decline, the value of these liabilities increases in a present value sense.

While I understand the mathematics of DCF calculations where a lower discount rate leads to a higher valuation that seems like an absurd accounting methodology to use because we are talking about a liability is not an asset.

When you are talking about liabilities if interest rates go down you are paying less interest on your debt for variable rate products. Obviously a debt which has a lower interest rate payable is less of a burden/liability than a higher interest rate debt of the same amount all things being equal. As for fixed rate debts, while theoretically the value of the liability may rise if you want to buy out the debt (e.g. if it is a bond) at current market value you must pay above par, in reality does this actual happen for pension funds? If you own a a five year government bond paying 2% interest p.a. and interest rates rise and the price and value of your bond drops, if you hold the bond to maturity assuming no defaults occur your return will be 2% p.a. irrespective of what the bond price does in the interim. The reverse is also true, if you are borrowing and interest rates drop and the market value of the debt goes up, if you pay out the debt at maturity/par then the theoretical increase in the value of the liability does not affect you.

It seems like distorted accounting/logic to say that if interest rates drop a debtor is worse off, with the specific exception being a situation where they are forced to buy back/pay out the debt above par.

I just can't get my head around the concept that declining interest rates are bad for a borrower/debtor (unless for some reason you must buy out the debt at market value above par). Do home home owners with a fixed interest rate mortgage panic when interest rates go down because the the net present value of the liability increased? That is absurd, if anything they will be happy that if rates stay low when their fixed rate expires they can rollover onto a lower variable rate. As for those with a variable rate mortgage they will be happy to paying a lower interest rate today.

 

[DeepState]

While I understand the mathematics of DCF calculations where a lower discount rate leads to a higher valuation that seems like an absurd accounting methodology to use because we are talking about a liability is not an asset.

A liability is a negative asset. It would be quite inconsistent to allow assets to be valued via DCF and absolve liabilities from the same. The value of a liability is essentially the value that the debtor would need to pay to someone else to take the liabilities off the books. It is a perfect mirror to the asset value which is the value the same entity would need to receive in order to take that asset off the books. [Ignoring considerations like market frictions, strategic matters, etc.]

When you are talking about liabilities if interest rates go down you are paying less interest on your debt for variable rate products. Obviously a debt which has a lower interest rate payable is less of a burden/liability than a higher interest rate debt of the same amount all things being equal. As for fixed rate debts, while theoretically the value of the liability may rise if you want to buy out the debt (e.g. if it is a bond) at current market value you must pay above par, in reality does this actual happen for pension funds? If you own a a five year government bond paying 2% interest p.a. and interest rates rise and the price and value of your bond drops, if you hold the bond to maturity assuming no defaults occur your return will be 2% p.a. irrespective of what the bond price does in the interim. The reverse is also true, if you are borrowing and interest rates drop and the market value of the debt goes up, if you pay out the debt at maturity/par then the theoretical increase in the value of the liability does not affect you.

Liabilities for defined benefit pensions and insurance companies are not variable rate products. If interest rates fall, their present value rises. This is unlike a floating rate security whose duration is essentially zero.

The argument about mark to market holdings is used for banks around the place where "hold to maturity assets" are maintained at book value unless impaired. However, the market looks straight through this chicanery when doing sum of the parts valuations.

The only time when, for the sake of determining solvency, that not marking to market results in a fair representation of what happens is when the assets used to support the claims and liabilities/claims are perfectly matched. If so, interest rate movements do not impact surplus. Still the prices at which you could sell or buy the values on balance sheet are not a true and fair representation of the state of the insurance company, for example. Leverage calculations would be off, as just one example.

If interest rates move, the value of the bonds with duration moves. If the assets and liabilities are not perfectly cashflow matched, this has an impact on their solvency. If so, it needs to be represented. Even if you will get 2% on the bond if held to maturity, that 2% may not be sufficient to meet liabilities whose value has increased by more (assuming the duration of pension payments, for example, vastly exceed those of most bonds). By not marking to market, all that is happening in deferring the recognition that solvency has been weakened.

Solvency is changed whether or not the bond was trading above/below par before then, or at acquisition. All that matters is the valuation. Typically, superannuation funds trade their bonds in anticipation of interest rate moves, relative value arguments, and changes to the liability structure.

It seems like distorted accounting/logic to say that if interest rates drop a debtor is worse off, with the specific exception being a situation where they are forced to buy back/pay out the debt above par.

Whether a debtor is better off or worse off for a particular situation depends on their wider circumstances. An over-funded pension fund might benefit from the same event that an under-funded pension fund finds detrimental. However, given many pensions are underfunded in an actuarial sense, we see these types of effects.

I just can't get my head around the concept that declining interest rates are bad for a borrower/debtor (unless for some reason you must buy out the debt at market value above par). Do home home owners with a fixed interest rate mortgage panic when interest rates go down because the the net present value of the liability increased? That is absurd, if anything they will be happy that if rates stay low when their fixed rate expires they can rollover onto a lower variable rate. As for those with a variable rate mortgage they will be happy to paying a lower interest rate today.

Home owners are usually on variable rates. They will benefit is rates go down immediately.

Home owners who are on fixed rates will end up paying more than they could have. The present value of these represents an increase in the present value of their mortgage payments. Whether or not they choose to panic is up to them.


Perhaps a review of the accounts of QBE to see what occurs for general insurance liabilities and Challenger to see how they treat the life insurance liabilities may be helpful. The Australian Public Sector Superannuation Funds (CSS/PSS) would be instructive in relation to actuarial treatment of defined benefit funds.

In Australia, Australian Accounting Standard AAS 25 is relevant.

In each case, liabilities which represent the present value of future payments whose value does not vary with movements in interest rates, as might a floating rate note, are discounted by actuarial methods for presentation to the accounts and for solvency reasons under governing legislation (overseen by APRA).

Where the interest rate sensitivity of the liabilities is greater than those of the assets, a fall in interest rates across the curve will result in an increase in value of the assets, but less so than the liabilities being discounted. This will reduce surplus. It makes it less certain that assets will be able to cover liabilities. It is an accurate economic depiction of what is going on. If surplus is being eroded, this will further reduce capacity for mismatch risk. It leads to purchase of more 'risk free' bonds as mismatch is reduced where possible.

I can empathise that this all seems weird. It took me some time to come to grips with it. For my sins, I used to run these calculations once upon a time.

FT Article for interest:View attachment Interest rate rise would fix pensions crisis — FT.pdf

 

[DeepState]

Deepstate, should we all go out and buy bonds and gold? Seems a no brainer, must a be a crowded trade by now though?

Gosh that was a good review. I really liked his linking QE to asset inflation in financial centers. Right there, we can see how monetary policy flowed not to the populace, but to a somewhat narrow demographic.

There's heaps to consider. I hold some gold because I do not fully trust fiat money and am happy to hold some of my 'offshore' currency exposure in the form of gold. This position has served well in my portfolio as a stabiliser.

As for bonds. I am currently undecided. "It's complicated."

 

[DeepState]

With a strong voting outcome for the LDP in Japan, event risk is high. Abe appears to have his mandate. The last effort at monetary easing was scoffed at. The IMF is saying double down.

 

[DeepState]

So we'll have another female Prime Minister in the UK shortly. Well done Theresa May.

She made several statements on accepting her nomination. If she can get these through, it would be a filip for progress towards a stronger society.

Economically, one statement stood out for me. She raised the prospect of government backed infrastructure funding/bonds. What an excellent idea. At pretty much zero real rates, any project which creates even the smallest return on capital and escalates with inflation, as infrastructure asset receipts tend to do, will produce a positive NPV. By being government backed, these bonds will enjoy an umbrella of the government yield curve for financing, with some adjustments for liquidity, although I'd expect them to be repo eligible as well.

Infrastructure spending has large economic multiplier effects. By financing them off balance sheet, the UK government avoids a ballooning federal debt, whilst stimulating productivity enhancing projects which will generate long term productivity growth whilst, at the same time, bringing corporate activity back into a higher gear in the nearer term.

In all, this is seen to be a key way to drag us out of a sluggish growth environment. It has been called for my the IMF, Krugman, Summers and even Bernanke has pointed it out as a way forward to bring economies out of their current funk.

 

[Triathlete]

As for bonds. I am currently undecided. "It's complicated."

Hi D/S, Do you have a view on corporate bonds???

 

[DeepState]

Hi D/S, Do you have a view on corporate bonds???

I own some and am looking at increasing exposure to the asset category.

 

[DeepState]

Have been working on FX in the last couple of months, seeing if any of my stuff transfers to that world. Trading commenced 3 May. Developed Market pairs. Nice start so far. 15 closed trades with one still open. +72%. A Minwa-like outcome. No wonder he wants to switch to FX.

Scaling up my position sizes progressively. At the moment, I still regard this as in the proving grounds and in the lab so am not full scale.

 

[qldfrog]

well done DS

 

[DeepState]

Reading the new Margin Trading Customer Agreement from IG Markets. Crikey, if the font were any smaller I'd have to enlarge it on a photo copier.

 

[minwa]

Reading the new Margin Trading Customer Agreement from IG Markets. Crikey, if the font were any smaller I'd have to enlarge it on a photo copier.

Lol I'm sure they sneak in using some technical language that basically allows them to close down your position if margined over and in negative territory, which easily happens when the spread goes super wide during volatile events while they are the market maker and price giver and that they can take the other side of your position without hedging themselves.

 

[cynic]

Lol I'm sure they sneak in using some technical language that basically allows them to close down your position if margined over and in negative territory, which easily happens when the spread goes super wide during volatile events while they are the market maker and price giver and that they can take the other side of your position without hedging themselves.

If memory serves correctly, the clauses covering those things, to which you allude, used to appear within their dozens of pages PDS in reasonable sized font.

However, whilst typing this post, I have noticed that in their more recent version, they've managed to compress their PDS down to approximately 21 pages, albeit with a much smaller font than the PDS versions I perused about a decade ago.

I suspect that these changes are in response to ASIC and/or FOS criticism regarding the voluminous nature of their customer agreement documentation in years gone by.

 

[skc]

Swiss bond yields now negative out to 50 years

There's little doubt that institutions are buying negatively yielding bonds for capital gains... but this is the first time I've seen it actually getting mentioned in the press.

http://www.afr.com/markets/market-d...d-bonds-to-make-capital-gains-20160721-gqb029

I am really baffled about how this can be sustained... as long as there's money flowing in, the party can continue?

It's hard to see this not end badly at some stage within my lifetime... makes me feel like hoarding tin food and go take a survival course with Bear Grylls.

 

[qldfrog]

Deep State,
i hope you do not mind me "hijacking" yopur thread:
I found teh following quite interesting:
http://www.brisbanetimes.com.au/business/the-economy/deutsche-bank-sees-world-economy-investment-reversing-for-the-next-35-years-20160909-grdacy.html
with a few more details on:
http://www.zerohedge.com/news/2016-09-08/global-demographic-shift

 

[DeepState]

Deep State,
i hope you do not mind me "hijacking" yopur thread:
I found teh following quite interesting:
http://www.brisbanetimes.com.au/business/the-economy/deutsche-bank-sees-world-economy-investment-reversing-for-the-next-35-years-20160909-grdacy.html
with a few more details on:
http://www.zerohedge.com/news/2016-09-08/global-demographic-shift

Unless we find a way to lift productivity way way up from current levels, the financial markets look set for a nasty time. The benefits of such gains need to spread out more evenly if there is to be a recovery in demand and good prospects for security in private debt.

It is felt by some that low productivity is arising from mis-reporting of quality improvements. That is, the Pokemon you are buying today is 10x better than it was 5 years ago despite it selling for the same price. That's a 10x real GDP growth from Pokemon. With the service/knowledge economy being such a large part of GDP, how to you measure the growth in value from a better trimmed beard? Yes, markets rise and fall on these determinations. Maybe the ABS, BEA, etc. are under-reporting the qualifty gains of Pokemon and beard trimming and all is actually much better than currently thought?

"And in financial news tonight, real beard trimming quality gains have pushed the June qtr GDP figure to 1.5%..."

It is very hard to find a reliable way to secure a real return right now.

 

[qldfrog]

"And in financial news tonight, real beard trimming quality gains have pushed the June qtr GDP figure to 1.5%..."

It is very hard to find a reliable way to secure a real return right now.

Can not agree more and when last quarter GDP figures are moved from recession to best of type as the result of more taxpayer money going into a new medecine listed on the PBS and an helicopter program (Hardware O/S purchase, not the throwing money out of the window type, actually not that different ) , this is craziness at its best.Yet it was all 25y wo recession pop the champagne celebration; in the middle of this, what do you do?
Protection of assets, cash, gold and real estate purchase this month (overvalued but hard to be confiscated);
currency protection as well, but I am in the belief the USD will start going down vs other currencies (not necessarily against the AUD) in the coming years and not that easy to by swiss Franc or remini.
This waiting game has been going on for too long..