Long-term Interest Rates Lower Than At any time Since the South Sea Bubble of 1720!

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Another Sign of Bond Market Madness?
It’s not just short-term interest rates that are at historic lows. There is now tangible evidence that long-term interest rates have touched new historic lows (Exhibit 1). Surprisingly few people took notice of the UK Debt Management Office’s (DMO) recent repayment of ‘undated’ debt, some originating from as far back to the 1720’s, and subsequent issue of new 50 year bonds. These transactions do, however, send a powerful signal. They should be seen as a warning that interest rates, both short and long-term, are not only low in absolute and real (inflation adjusted) terms. But they are now lower than at any time in the last 300 years!!!

Exhibit 1: UK Base Rate & Long-Term Yields 1694 - 2015

Source: Bank of England


Masterly Inaction –Until Now
The UK’s Debt Management Office (DMO), which oversees the issuance and redemption of the UK’s national debt, is widely recognised as one of the world’s most astute and well informed operators in the debt markets. Until this year, the UK government was paying interest on eight undated gilts (UK government bonds are called ‘gilts’), some of which had their origins going back to the beginning of the 18th century. The term ‘undated’ refers to the fact that these gilts had no fixed maturity date, only a date after which the government had the option to redeem (repay) the debt if it so desired. In reality, the ever increasing amount of government debt, and low interest rate (coupon) on the original debt, meant that the UK government never had a desire to repay this debt. Until now.
In October 2014, a review of these ‘undated’ securities concluded that the redemption and refinancing of these securities would provide taxpayers with value for money. In other words, for the first time in 300 years, the DMO judged current long-term interest rates were so low the debt could be re-financed (i.e. new bonds issued) at an even lower rate.


From the South Sea Bubble to the Current Bond Bubble?
Of the eight ‘undated’ gilts redeemed, the oldest was the 2 ½ % annuities, issued in 1853. It was then that the then chancellor, William Gladstone, consolidated the capital stock (shares and 3% annuities) of the South Sea Company which had collapsed in the infamous South Sea Bubble financial crisis of 1720.

Exhibit 2: South Sea Company Share price


Source: Wikipedia

For those less familiar with financial history, the South Sea Bubble was a speculative bubble in the early 18th century involving the shares of the South Sea Company. The British trading company was granted a monopoly in trade with Spain’s silver and gold-rich colonies in South America and the West Indies, in return for assuming England’s debt for the War of the Spanish Succession. Nearly all classes of British society got involved in wild stock speculation and when the bubble popped many investors were ruined (Exhibit 2). Isaac Newton was one of those ruined by the collapse in price. A tough lesson in the laws of gravity! Newton was quoted as saying, "I can calculate the movement of the stars, but not the madness of men".

The Madness of Crowds: Record Demand for 50 Year Gilt Offering a Record Low Yield!

The last remaining ‘undated’ bonds, some originating from the South Sea Company, were redeemed on the 5th July, this year. As if to underscore the ability to refinance this debt, on 21st October, the DMO issued an ultra-long 2 ½% gilt which matures in 2065. Enjoying strong demand, the GBP4.75bn issue received orders worth a whopping GBP21.9bn. According to a DMO spokesman, that was the biggest order book ever for a syndicated gilt sale (the previous record being GBP16.5bn in June, 2014). The success of this bond issue would seem to confirm the view that today, long-term interest rates are indeed lower than at any point in the last 300 years. The scarcity of long dated debt and low inflation were cited as reasons for the strong investor interest. 

Is it a bond market bubble?

Recent inflation data, from the UK and elsewhere, suggests there are risks of deflation. The UK, for example, saw the Consumer Price Index (CPI) fall in September by -0.1% Y-on-y. Against that backdrop, a 2.5% yield on 50 year debt or 1.8% yield on 10 year debt doesn’t look so bad. But that’s not the whole picture.

Exhibit 3: UK 10 Year Gilt Yields (Black) Expected Inflation (Yellow), Consumer Price Inflation (Green) & Consumer Price Inflation, ex energy). Recessions Shaded (Red)


Source:Bloomberg

Digging deeper, numerous inflation risks can be identified.
Headline inflation numbers have been impacted by falling energy prices. In the UK, for example, adjusting for the fall in gasoline prices brings UK CPI up from a negative -0.1% to +1.0%. Energy prices won’t keep going down indefinitely. 
Market implied inflation expectations (comparing conventional versus inflation linked bonds) are for 2.4% p.a. inflation over the next 10 years. This is higher than the yield on 10 year bonds (1.9% p.a.).
The Bank of England has an inflation target of 2% p.a. Again, that’s higher than the current 10 year bond yield
Falling unemployment will eventually feed into higher wage demands and inflation
Asset price inflation, e.g. property, shares, eventually feeds into consumer prices (wealth effect and consumer confidence).
Exhibit 3, shows UK 10 year bond yields against various measures of inflation. Historically, bond investors have enjoyed a yield significantly higher than expected inflation. But not, it appears since the 2008/9 crisis. So why investors are accepting negative ‘real’ returns? It’s not as if higher returns are not available elsewhere, e.g. equities, commercial property. Indeed, another anomaly since the 2008/9 financial crisis is that equities now offer a significantly higher yield than government bonds.
  
Exhibit 4: Gilt Yields (10 Year) versus Dividend Yields



The average dividend yield on the UK FTSE100 index is currently 4.1% compared with 1.9% on 10 year gilts (Exhibit 4). The figures for the Czech stock and bond markets are 4.4% and 0.5% respectively.

Since the 2008/9 financial crisis, there would seem to be an element of artificiality about the current very low yields on government bonds. They cannot be explained by reference to history, to the outlook for inflation or the yield on alternative assets, such as equities.

An Artificial Market in Government Bonds?

Two factors have combined to push down bond yields to their current extremely low levels, measured in either absolute terms or relative to inflation expectations.

Global Quantitative Easing (QE) policies have involved central banks buying huge amounts of government debt. These policies have helped squeeze-up the prices (lowered the yields) on government debt globally. It is estimated that the European Central Bank (ECB), Federal Reserve (Fed), Bank of Japan (BOJ) and Bank of England (BOE) have bought 14%, 18%, 16% and 27% of their respective bond markets. While the ECB may well continue its QE program into next year, the QE buying is somewhat transient in nature and will eventually end.

 Financial Repression means that regulations (many imposed in response to the 2008/2009 crisis) have pushed investors into owning more government bonds than they might otherwise. Banks, pension funds, and to some extent mutual funds, are all subject to regulations that favour owning government bonds. Along with QE, Financial Repression has created an artificial market in government (and many other) bonds.

But What about the Czech Bond Market?

So far the discussion has focused on the UK gilt market because of its long history and the recent actions of the UK government in refinancing some extremely old debt. Many of the issues raised in the UK gilt market apply equally to Czech and other government bond markets.
Indeed, Czech bonds trade at incredibly low yields, in fact lower than the equivalent yields of the UK gilt market. (As of writing, 10 Year Czech government bonds currently yield 0.5%p.a. compared with 1.9%p.a. for the equivalent UK gilt). Financial Repression is clearly a major issue here in the Czech Republic. Regulations have resulted in banks and pension funds holding huge quantities of Czech government bonds. Interestingly, for both Czech banks and pension funds, their current high exposure to Czech government bonds looks both undesirable and unsustainable.  
In addition, much of the demand for Czech bonds comes from investors unwilling or unable to accept any currency risk. Should the Czech Republic move towards the adoption of the Euro, the premium investors are prepared to pay for Czech Crown denominated bonds would disappear. Why hold a 10 year Czech bond if say a French bond gives you twice the yield? Investors in long-term Czech bonds are therefore gambling that the Czech Republic won’t adopt the euro any time soon.

Feeling a Bit on Edge?

Uneasy about those long-term bonds you’re holding? Well, you’re not the only one. Bond markets have recently become much more prone to sharp price movements, e.g. Oct. 2014 in the US Treasury market, May 2013 in the Japanese Government Bond market. Again, all is not what it seems. Much of current day bond trading represents so called High Frequency Traders eking out tiny profits by trading huge volumes. Despite the volumes, they have minimal capital committed to the bond market. Similarly, post the 2008/9 crisis, investment banks have dramatically downsized the size of their trading books. Worryingly, many investment banks have linked the size of their trading books to measures of short turn volatility, e.g. Value-at-Risk (VaR), Expected Shortfall, etc, which means, in any sharp downward move in bond prices, investment banks have become the first to sell. A source of instability rather than stability. The targeting by some Japanese banks of a ‘constant VaR’ exposure is a particular worry. It forces selling of bond positions immediately prices drop sharply/volatility rises. For readers interested in the systemic risks caused by the widespread use of quantitative risk models, these issues are discussed by the author in VaR from Perfect: The Unintended Consequences of Setting a Limit to Calculated VaR, July 2003, published on the Czech CFA website.

At AKRO investiční společnost, we’re not asking if there will be a bond market correction, we are just debating: When and by how much? Current bond prices defy both history and fundamentals. It is easy to speculate on the potential catalysts for a correction (rising short-term interest rates by the Fed/BOE, inflation data, rising commodity prices, the end of ECB intervention). My own favourite is a shock emanating from US wage inflation, where the current rate looks anomalously low. In reality, the catalyst for a bond market correction may be none of the aforementioned. Many market corrections have little in the way of breaking news…they just seem to happen and commentators are left trying to dream-up explanations later. Market confidence can be a very fragile thing.

Concluding Remarks

Stock market historians may well look back on the redemption of the UK’s ‘undated’ bonds and record demand for new 50 year gilts as representing the high point in the current bond market bubble; in much the same way as the AOL/Time Warner merger transaction represented the high point in the ‘dot com’ bubble of 2000, or The Royal Bank of Scotland’s ambitious take-over of ABN-AMRO represented the pinnacle of bank recklessness prior to the 2008/9 credit crunch.
There would be some irony if South Sea Company debt, originally issued during the speculative madness of the early 18th century, should have been finally redeemed as a consequence of another bubble 300 years later.

Jeremy Monk, MBA, ASIP, BSc(Hons), DIC
Investment Director,  AKRO investiční společnost, a.s.


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