Bond Market during deflation

[Sten Sture]

Originally posted by DAVOUT


When the yield increases, a bond valued 100 before the increase will be valued less because investors are no longer willing to pay 100 to get only the previous rate.

Same thing, but reverse when the yield decreases.

But that only applies to nominal, not real yields, which was confusing in your first post...

[Kidlicious]

Originally posted by Sten Sture
Ever heard of that stuff Shares? (I shorten it to corpfin...)

Does this lead to excess liquidity? That is, do people hold more cash? Not intentionally, but defacto because of the transactions occuring in the refi side of things, more cash is held temporarily as the old mbs (mortgage backed securities) are paid back and the new ones are issued. There is a peculiar time delay in the american mbs market of 15 or 25 days (FNMA and FHLMC are on different schedules) between the accrual period and the interest and principle payment dates. Somewhat similar to stocks going ex-dividend. If I own a 30yr FNMA 6% pool in April, then I know that refi's are going to be pretty high, but my payment doesn't come in until May 25th, so that cash is in transit between various intermediaries from the 1st or 5th or whenever the borrower closes on their new loan.

The number of securitized loans in the American mbs market is monsterous. Very few lending institutions retain their mortgage production, favoring the liquidity, and diversity of buying generic pools of loans from all around the country. What they do retain is the servicing of the loans that they make, which generally keeps about 50 basis points (0.50%) of the interest.

In a deflationary environment, you want as much duration (maturity adjusted for interest cash flow) as you can get in your portfolio, that is one reason we have seen bonds rally so much over the past couple of years. DAVOUT's first post was a little confusing in that regard. As nominal interest rates decline, bond prices go up, and go up a lot more as they get really low, because of their positive convexity. They get less cash flow the lower yields go, and their duration extends.

Deflation makes bonds extremely valuable, unless you are talking about large declines. 2% is not significant. Your fixed future cash flows will buy more goods in the future, while a stock represents declining cash flows since they are selling their products for less money.

Interesting.

When the yield (nominal) on bonds approaches zero do you believe that bonds become a perfect substitute with cash and if so wouldn't that make cash less risky and more desirable?

[TCO]

Originally posted by DAVOUT


When the yield increases, a bond valued 100 before the increase will be valued less because investors are no longer willing to pay 100 to get only the previous rate.

Same thing, but reverse when the yield decreases.

hmmm. I guess I was talking about the new bonds issued and you were talking about the old ones. My mistake there.

But I still don't buy your argument. Do an NPV on the existing bonds. Deflation makes the old bonds have a higher real interest rate. So their NPV goes up. (And the changing interest rate is irrelevant! That only affects new bonds issued.)

[Kidlicious]

Originally posted by Sten Sture
got the folks in town today; I'll be out for a while... cheers.

Ahhhhh... Just like professors who don't like to stay after class to explain stuff

[Kidlicious]

All right how many people would buy bonds with a nominal yield of zero or close to zero? I would do a poll, but I'm not expecting a lot of votes?

[DAVOUT]

Originally posted by Sten Sture


But that only applies to nominal, not real yields, which was confusing in your first post...

You are right, old bonds enjoy deflation as well.

[Kidlicious]

DAVOUT: Is that a yes to my poll?

[DAVOUT]

Your question was :

there will be a sustained period of deflation in the US. You may or may not believe that that will happen, but just assume it. Will that be good for the bond market or will it cause a bubble to burst?

My answer is Yes, will be good.

You asked also :

If a bubble does burst in the bond market what will be result?

When the deflation will end, which will occur sooner or later, there will certainly be a burst (not comparable to the TMT bubble on the stock exchange); a lot depends on the pace of the rate increases which will follow the end of deflation.

[Kidlicious]

Originally posted by Kidicious
All right how many people would buy bonds with a nominal yield of zero or close to zero? I would do a poll, but I'm not expecting a lot of votes?

And your answer to this is yes?

[DAVOUT]

Originally posted by Kidicious


And your answer to this is yes?

Bonds with zero nominal rate versus cash :

The fact that cash is readily available is worth something, partly offset (or increased) by handling cost which could be different (I dont know what they are). I therefore see no reason to buy bonds at 0%.

If needed, another reason would be that for the owner of a bond at 0%, the only prospect is an rate increase which would reduce the price of his bond.

But I dont know if this is a Yes or No answer

[Kidlicious]

Originally posted by DAVOUT


Bonds with zero nominal rate versus cash :

The fact that cash is readily available is worth something, partly offset (or increased) by handling cost which could be different (I dont know what they are). I therefore see no reason to buy bonds at 0%.

If needed, another reason would be that for the owner of a bond at 0%, the only prospect is an rate increase which would reduce the price of his bond.

But I dont know if this is a Yes or No answer

Well you are thinking along the same lines as me, and my answer is no, but I don't know what the handling costs are either. I wouldn't keep a safe unless I was in a very safe area.

edit: I guess you could just keep it in a savings account. There it wouldn't be sensitive to price declines except for inflation. And at that point you could buy some stocks.

[Sten Sture]

Originally posted by Kidicious
When the yield (nominal) on bonds approaches zero do you believe that bonds become a perfect substitute with cash and if so wouldn't that make cash less risky and more desirable?

No. For government bonds (with effectively zero credit risk) cash is just a zero day bond. Invested cash (repo or whatever) is a one day bond. Cash predicts the value of money over a VERY short time horizon. Bonds predict the value of cash over a much longer time frame. So even if a ten year bond/note is trading at a yield that gives it a zero nominal yield it would be very different from cash because it locks in a cash flow for the future. Even if that cash flow is just the principle repayment on a zero coupon bond. Cash cannot guarantee that it will pay you an equivalent amount in ten years.

In fact though, even in a mildly deflationary climate like Japan today, the yield curve is very steep, as longer term yields are significantly higher than short term yields. And as is logical corporate borrowing rates are significantly higher than government bond rates. In a deflationary environment corporate credit risk is higher, due to declining revenues, therefore available interest rates for investors are going to be significantly higher than zero.

My call on deflation is that it is very difficult to sustain without having capacity reduced. Japan, because of their soviet planned economy, can maintain excess capacity. In most of the world plants can be closed, employees can be laid off, and capacity can be removed from the system. In fact we are seeing that now, and my greater concern is the inflation that follows.

[Kidlicious]

Originally posted by Sten Sture
Cash cannot guarantee that it will pay you an equivalent amount in ten years.

I can't lose money with bonds?

Of course I can right? That's why there's a market. People speculate with them. So I can't figure out why I should risk losing money on a zero percent bond.

[TCO]

Wait, I don't get it. I would rather have cash than a zero nominal yeild bond (nominal means the denoted interest rate, right?) The only advantage of the bond would be storage and handling. The cash allows for me to invest at some later time, if the deflation changes. With the bond, that option value is gone.


If deflation deepens, I'm benefitted the same with cash or with a bond. (return is the same right?) If we move to inflation, I am benefitted by cash rather than a low interest bond, since I can invest it in new bonds.

[Kidlicious]

Yep.

edit: btw, the 10-year govt bond yield in Japan is below 0.6% now.