How the Bond Market Works

Or how it should, amid excess credit, capital shortage...

The AUTHOR and journalist Michael Lewis claims that when he wrote 'Liar's Poker', which was published 35 years ago, he meant it as a cautionary tale, writes Tim Price of Price Value Partners.

The book happens to be required reading, not just for anyone seeking an insight into the ways of Wall Street in the late 1980s, but simply for anyone, full stop.

It's a terrific read, and it charts a period during which something approximating to 'gentlemanly capitalism' was taken over, wholesale; first by street-smart traders from the likes of the Bronx and London's East End, and then by quantitative analysts (geeks, in other words, but with PhDs).

It also details a period during which the bond market started to dominate every other facet of the investment world. "I used to think that if there was reincarnation," said Clinton political adviser James Carville once, "I wanted to come back as the president or the pope or as a .400 baseball hitter.

"But now I want to come back as the bond market. You can intimidate everybody."

'Liar's Poker' portrays a world in which cunning slobs stole dealing rooms from under the noses of patrician blue-bloods born on the right side of the tracks. If that implies chaos, that's exactly right.

But cautionary tale? The book became 'must-read' material for an entire generation of undergraduates on both sides of the Atlantic. It acted like a giant vacuum cleaner, sucking up mathematicians and philosophy students and economics third-years and liberal arts graduates, and spitting them back out across dealing rooms in New York and London's Square Mile.

For all we know, it still does. This correspondent speaks as an English graduate whose first job, courtesy of exposure to 'Liar's Poker', was – like Michael Lewis – selling bonds for an international investment bank.

The bond market may be intimidating, but it shouldn't be. A bond is about the most basic financial instrument you could imagine. Think of a loan that happens to be tradable, daily.

That's a bond.

So let's put some more meat on the bone. Who issues bonds? Anyone that needs to borrow money. That means governments, corporations, and supranational borrowers like the World Bank.

Entities, especially private companies, often prefer to borrow in the bond market because they don't want to dilute existing shareholders by means of issuing equity. US companies also often prefer to issue bonds as opposed to stock because the interest on bonds is deductible on the company's income tax return. Dividends on stock are not.

The bond market is an almost entirely institutional market. Private investors barely feature – not least because the average traded size for a bond deal in the secondary market is approximately $5 million or so.

How do bonds get issued? In a way that's very similar to equity underwriting. A consortium of investment banks will gauge the market's level of interest in the issue by speaking to their clients – large pension funds, insurers, hedge funds, and sovereign wealth funds. When they've assessed the market's demand for the issue, the size of the borrowing will be agreed, and its price, and then the bonds will be free to trade. Voila.

Bond math is pretty straightforward, too. Let's take a real world example. (Market professionals can skip the next few paragraphs.)

A corporate issuer – let's call them 'General Industrial' – decides to borrow $5 billion in the bond market at an interest rate of 5%, maturing in 10 years' time, on 3rd June 2034. Let's say you're a pension fund and you decide to buy $1 million worth of the issue at launch. You will pay 100% of the bond's face value, or what's known as par. So the stream of cash flows looks as follows:

Launch date: you pay General Industrial (or more specifically, the investment bank from whom you bought the bond) $1000,000.

3rd June 2025: General Industrial pays you $50,000 (5% of your $1000,000).
3rd June 2026: General Industrial pays you another $50,000.
3rd June 2027: General Industrial pays you another $50,000...(you get the picture).

...and on 3rd June 2034, General Industrial pays you a last coupon payment of $50,000 – and it also pays you your original principal of $1000,000 back.

As you can see from this example, bond interest payments, or what are called coupons, are typically fixed. And the redemption of your initial capital is fixed, too, at 100%.

This means that in a high inflation environment, bonds are generally poor investments. The converse is also true. In a deflationary environment, where prices are actually falling, bonds are generally great investments, because the purchasing power of your capital is actually improving, relative to those falling prices.

It's important to know that you're not locked in to holding this bond until it matures in June 2034. You can sell it any time you like. Although the coupon is only paid once a year (bonds typically pay annual or semi-annual coupons), if you decide to sell it before the coupon date, you'll be compensated for any accrued interest that you've earned but not been paid.

And it's also critically important to know that if General Industrial is unable to pay the interest it owes you, or to repay the initial capital when the bond matures, you may lose everything.

For this reason, almost all bonds carry a credit rating from a major ratings agency like Moody's or Standard & Poor's. Credit ratings range from 'AAA' (impeccable) all the way down to 'D' – meaning the company is in default. 'Investment grade ratings' (the best sort) range from 'AAA' to 'BBB-'. Anything below that is considered 'junk', or more politely, 'high yield'.

So what influences the price of bonds? The major factors are: the likely direction of future interest rates; the likely direction of inflation; supply and demand for the bonds in question; and the perceived credit quality of the issuer.

One final word on bond math. There is one thing close to an iron law in economics. If interest rates go up, bond prices typically fall. (The converse is also true.)

Why? Remember, those interest payments, or coupons, are typically fixed. The capital amount returned when the bond matures is also fixed, too. So if interest rates rise while you're holding the bond, the value of those fixed payments essentially is diminished in real terms. But because the bond trades every day, bond traders can adjust the price of the bond, which in turn will adjust the yield that the bond offers.

If you buy that General Industrial bond at a price of 100 when it's issued, because the coupon is fixed at 5%, your yield will be 5%, too. Over its life, if the price falls below 100, your yield (what bond traders call 'yield to maturity') will rise. And clearly, if investors raise their opinion of General Industrial's credit quality, then the price of the bonds is likely to rise too. But the critical point is the one we just made:

If interest rates go up, bond prices typically fall.

Before we leave the subject of bonds altogether, it's also worth saying a few words about the nature of bond fund managers. Institutional bond funds typically invest on an indexed or benchmarked basis. That is to say, they will tend to own bonds in line with the make-up of an accredited bond index, such as the JP Morgan Government Bond Index.

Think about that one more time. A bond fund tracking a bond index is effectively obliged to have its largest positions in the largest bond markets. This is a bit like saying you can lend to one of two friends. One of your friends wants to borrow $10, and is good for the loan. The other wants to borrow $1000,000 – and is frankly unlikely to pay it back. You are obliged to make the loan to your second friend, who's clearly a credit risk. Welcome to the perverse and dangerous logic of international bond investing. We think this will end in tears.

A modern economy is clearly a complex structure, so rather than have to get a PhD in advanced economics just to conduct credit research on any given government bond market, most investors leave the credit analysis to the likes of those ratings agencies, Moody's, Standard & Poor's, and Fitch IBCA.

But at the risk of appearing overly deferential to those same agencies, the subprime mortgage disaster showed that they can have feet of clay. Collateralised debt obligations (packages of subprime loans) were rated 'AAA' one day and defaulted the next.

So for the avoidance of any doubt, take credit ratings with more than a pinch of salt. Remember that credit ratings agencies are paid by the same borrowers for whom they provide credit ratings – a larger conflict of interest would be difficult to imagine.

If you're in need of a further jolt of realism, visit the US debt clock. The site confirms that the US national debt now stands at just under $35 trillion. With a 't'. That equates to debt per taxpayer of roughly $267,000. That's the good news. When you factor in the unfunded liabilities of the US government (the likes of Social Security and Medicare), the US debt comes to well over $200 trillion. Also with a 't'.

We humbly submit that these debts will not be paid back. They cannot be paid back. The US national debt is like a neutron star: an incalculably dense mass that crushes everything that comes towards it.

But ratings agency Fitch cheerfully gives the US a credit rating of 'AA+', its second highest rating. Ominously, though, it downgraded the US from its highest rating of 'AAA' in August 2023.

With hindsight it made absolute sense to buy US Treasuries in the early 1980s, for example. The oil shocks of the 1970s had given rise to years of stagflation and it was only Fed chairman Paul Volcker's determination to squeeze inflation out of the system through the tough love of higher interest rates that brought bond markets back under control.

And how. Starting in 1982, Treasury yields started to drop (bond yields move inversely to bond prices – so lower yields means a bond market rally), and they fell precipitously.

By mid-2020, 10 year US Treasury yields were trading below 1%. But that was then.. They are now back above 4% – and we think they are heading higher. The market consensus does not agree with us.

But there's worse news to come. Treasury yields are only as low as they are due to the Federal Reserve's policy of Quantitative Easing (QE). QE was "designed" as a means of boosting the economy through the provision of additional liquidity into the banking system. The Fed would create 'ex nihilo' money – money out of thin air – and use it to buy bonds in the secondary market from the banks. Gifted free cash through these bond sales, the banks would then lend out this newly created cash to those who wanted to borrow. That was the theory.

In practice, all that's really happened is that QE has blessed a small proportion of the population – those lucky individuals fortunate or successful enough to hold large amounts of financial assets. QE has been an extraordinary boon to the asset rich. Equity prices, bond prices, housing prices have all benefited from a colossal leakage of money from the banking system into the financial markets. But this leakage has now been officially ended.

This doesn't mean that interest rates are immediately going to rise. But the formal cessation of the latest round of QE is equivalent to a sea change in US monetary policy. At some point, interest rates must rise. And to repeat, if interest rates go up, bond prices tend to fall.

And because the West is drowning in bonds, the impact of a bear market in bonds is incalculable.

If you accept our argument that the investment world is beset by a type of uncertainty genuinely never seen before – one that incorporates interest rate risk, default risk and currency risk on a literally global scale – then it makes sense to hold a type of asset that is either unexposed to those risks or that offers the potential to insure your portfolio against them. That asset is gold.

"We have an abundance of money and credit..." writes our friend Tony Deden, a money manager in Zurich,

"...but a shortage of capital. We have sought to substitute form over substance, credit over savings, and consumption over production. We have eaten our capital...we live in dismal times and we suffer from a moral crisis, both being consequences of a [50-year old] experiment in dishonest money.

"In the end, the consequences of monetary folly have not been addressed but only postponed. The errors have not been cleared but merely covered up with money and false accounting. Money printing can buy time but not wealth. All roads lead to default and impoverishment of some sort. The only question that remains is what road will be taken."

The beauty of gold versus all other types of asset is that it is the only one that is also no-one else's liability. It is independent, scarce, and permanent. That cannot be said of any fiat currency. As you might expect, we regard gold not just as an industrial commodity, but as an alternative form of money.

One of Tony's directors once made a highly pertinent observation about what gold actually is:

"Gold is not an investment. It is a conscious decision to refrain from investing until an honest monetary regime makes the rational calculation of relative asset prices possible."

Suffice to say, the return of an honest monetary regime may be some time off. But precisely because we don't know what the future holds, and because the threats to our purchasing power are numerous and very real, we maintain that gold has a place in any balanced portfolio today.

Incrementum AG:

"One of our central theses of recent years is now being slowly but surely confirmed: (Government) bonds are no longer the antifragile portfolio foundation they have been for the last 40 years. After yields reached a microscopically low level in 2020 and were even negative in some cases, 10-year US Treasuries fell in value by 22.8%, while 30-year bonds even fell by 48.8% from their peak. The frontrunners in the negative sense are naturally the 100-year Austrian bonds, which are down 69.1 % (maturity 2120) from their respective highs.

"It almost seems as if the bond vigilantes are back. Coined by Ed Yardeni in 1983, the term refers to activist investors who indirectly control government policy by buying and selling government bonds. These "financial sheriffs" send a clear signal against excessive government debt and inflation by driving up interest rates through the sale of bonds. Today, in a time of financial repression and open central bank interventionism, their role may seem weakened. But the bond vigilantes are not obsolete – they are adapting to the new market realities and remain an important corrective to fiscal slippage.

"A historical example of the impact of bond vigilantes was the bond market reaction to the overexpansive fiscal policy of the Reagan era in the early 1980s. Higher deficits led to a rise in government bond yields, which ultimately prompted the government to tighten its budget policy. Another example is the European sovereign debt crisis in the early 2010s, when investors questioned the creditworthiness of southern European countries and drastically increased the interest burden for these countries by selling PIIGS bonds.

"And the playbook is likely to have changed not only for gold but also for bonds. Recently, US government bonds have increasingly exhibited characteristics of traditional risk-on investments. In times of financial unrest, their yields rose – a clear contrast to the previous trading pattern that dominated for decades. This new behaviour is reminiscent of the performance of emerging-market government bonds, which are traditionally more sensitive to global risk sentiment. This transformation marks a significant departure from the previous role of [US Treasuries] as a safe haven, and it requires a rethink in strategic allocation."

In common with Incrementum, we think much has changed. Although anecdotal evidence suggests that our wealth management competitors still see merit in the so-called '60/40 portfolio' (60% equities; 40% bonds; both benchmarked against traditional market weight indices), we see none whatsoever. We see no merit in fiat currencies or bonds issued by heavily indebted sovereigns that have no realistic way out of their current debt predicament other than via an explicit and highly repressive policy of state-sanctioned inflationism. Conversely, we see huge merit in the stateless, creditless, apolitical opportunities represented by the likes of gold and silver and sensibly priced commodities companies – and we are invested accordingly.