Archive for the ‘Bonds’ Category

Is the Greek debt crisis over?

Sunday, April 18th, 2010

When you read the latest statement on monetary policy decision of the Reserve Bank of Australia (RBA), you will find that they believe that the Greek sovereign debt crisis is contained for the moment:

The concerns regarding some sovereigns appear to have been contained at this stage.

The language is reminiscent of the start of the sub-prime mortgage problems. Currently, it seems that the global financial markets are shrugging off the possibility of a Greek government debt default, which has a wider implication on the Euro as a currency, which in turn has a wider implication on the global financial markets (see All quiet on the Greek front?).

But dear readers, do not be fooled by this apparent calm. Sure, the concerns looked ?contained? but the problems are still simmering. To let appreciate this situation, look at the following facts:

  1. Greece has to pay 4% more for their debt than Germany, the most credit-worthy nation. That?s roughly twice the margin from January 2010, at the height of the financial market jitters.
  2. The most recent attempt by the Greek government to raise money was very undersubscribed.
  3. Greece needs around ?50 billion in 2010, of which around ?25 billion is needed by June.
  4. After 2010, the Greek government needs to refinance its debt at 7-12% of its GDP.
  5. Greece budget deficit currently sits at 12% of GDP and must be financed as well.
  6. Greek government debt is forecasted to be over 150% of GDP by 2014.
  7. The current ?bailout? package by the EU and IMF is around ?40-45 billion, which is short of what the Greeks need at ?50-75 billion.
  8. The ?bailout? package requires:
    1. ? that Greece must exhaust its ability to borrow from the financial markets first before accessing the package.
    2. ? unanimous agreement among EU members.
    3. ? the debt will be provided at market rates, rather than on concessionary terms (although under new proposals full market rates will not be used).
    4. ? full participation of the IMF, which means the IMF will have a say in the (usually stringent) conditions for the loan.
    5. ? meet Germany?s condition that the EU framework for future bailouts be changed.

As you can see, the Greek problem is going to be more like a trench warfare than a blitzkrieg. It will probably take years, taking down lots of casualties on the way.

Mind you, Greece is not the only country. There are other countries like Portugal, Ireland, Italy, Spain and UK who are going to face the same problem over the next few years. The question is, while the trench warfare is going on in the Greek front for the next couple of (or few) years, can the global financial markets remain orderly when one or more of the Portuguese, Irish, Italian, Spanish and British fronts are opened simultaneously?

Fingers crossed.

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Posted in Bonds, Currencies | 9 Comments »

How is the Fed going to keep the lid on inflation? Part 2- Paying interest on bank reserves

Sunday, February 14th, 2010

In our previous article0 (How is the Fed going to keep the lid on inflation? Part 1- Losing control of the Fed Funds Rate), we discussed about how the Fed is considering using the interest rates on reserves (instead of the Fed Fund Rate) as the benchmark rate. Some observers may ask this question: with so much excess bank reserves in the financial system, how is the Fed going to drain them out of the system in order to contain price inflation?

As it turns out, the Fed has one trick up its sleeves. The jury is still out on whether this trick will work or not. We guess this trick may work in the short term, but in the long run, we have our reservations. The trick is this: increase the interest rates on the bank reserves. How will it work in theory?

You see, traditionally, the Fed did not pay interests on bank reserves. As we mentioned before in How is the Fed going to keep the lid on inflation? Part 1- Losing control of the Fed Funds Rate,

… the whole point of banking is to get the banks to lend out their money to the wider economy. By not paying interest on reserves, they became unproductive assets. Thus, that prodded the banks to lend out their reserves to make their assets more ?productive.?

In the post-GFC world, the Fed pays interests on bank reserves. If you are a commercial bank, you will only lend money to someone if the returns on the loan is greater than the returns on your reserves. Therefore, the more the Fed increases the interest rates on your reserves, the less likely you will lend it out. That will result in short-term interest rates to rise.

As you can see by now, because of the dysfunction of the financial system post-GFC, the Fed Fund Rate has less and less influence on short-term interest rates. Instead, the bank reserves interest rates become a more effect control.

The question is, will the Fed’s trick work? We will talk more in the next articles. Keep in tune.

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How are bond vigilantes neutered?

Sunday, December 13th, 2009

In our previous article, Rating agencies doing the job of bond markets, we said that bond vigilantes are being neutered. It didn’t occur to us that we had skipped a few steps and some of our readers were wondering why is it so. Our apologies. Here, we will explain why…

First, you have to understand that bond yields and bond prices are inversely related. Why is this so? As we explained in Rating agencies doing the job of bond markets,

For example, if you pay $100 for a newly issued 10-year government bond that pays 6% per annum, you are sacrificing $100 of today?s consumption in order to receive $6 per year for the next 10 years. That 6% is your rate of return on your investment. Now, let?s say you decide to sell your government bond to Tom at $90. The rate of return for Tom is 6/90 = 6.67%. Let?s say Tom sells the bond to Dick at $110, the rate of return for him will be 6/110 = 5.45%. Thus, the rate of return of the bond is inverse to the price paid for it.

What the bond vigilantes do to keep governments accountable is that whenever they perceive governments to be too foolish with their finances (e.g. printing too much money, borrowing too much, etc), they sell off their holdings of government bonds. That in turn will depress the price of government bonds, which imply increases their yields.

The free market is supposed to determine the price of the longer-term government bonds, which implies that long-term interest rates are set by the free market. Therefore, long-term government bond yields are supposed to be an indicator of the trustworthiness of government borrowings. For example, if the free market expects high inflation, then it will be reflected in high bond yields. Conversely, if the free market expects deflation, then it will be reflected in low bond yields.

However, in reality, the price of long-term government bonds are not totally free. Central banks of major nations (e.g. Federal Reserve, Bank of England and Bank of Japan) interfered in the price of long-term government bonds by creating money out of thin air to buy up those bonds. That created additional demand for government bonds, which pushes up its price, which in turn imply lower bond yields than otherwise.

Because central banks is the only authority allowed to create money out of thin air, they can conjured up infinite quantities of money to support bond prices (i.e. “do whatever it takes” to prevent bond prices from falling). Bond vigilantes as a whole do not have infinite resources to push down the yield of bonds. That’s why they are neutered by the central banks.

What happens to the bonds that the central bank purchased? It enters their balance sheet as an ‘asset.’

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Posted in Bonds, Investor Education | No Comments »

Rating agencies doing the job of bond markets

Thursday, December 10th, 2009

Traditionally, the bond market is where governments are kept accountable. In the 1980s, after the inflation nightmare of the 1970s, we have the bond ‘vigilantes’ who watched money supply growth like hawks. Any governments that print money will be punished by the bond vigilantes selling government bonds, thus raising their yields.

Today, the bond vigilantes are neutered. Central banks (obviously we don’t have to name names here) are buying up their governments’ bonds to prop up their prices. This means government bond prices cannot fall. That in turn makes government bonds an attractive destination for those who wants to preserve their capital. The bond vigilantes cannot do their job of punishing irresponsible governments.

Long-term interests was supposed to be determined by the free market via long-term government bond prices. That is supposed to reflect the market’s belief about long-term price inflation rate and the governments’ ability to honour its debts. Today, with governments (via their central banks) sticking their dirty paws on the bond market, bond prices are useless indicators of the credit-worthiness of governments.

Now, we have to rely on credit rating agencies to do that job. This week, the Greek government was infamously downgraded by Fitch. Greek government debt is on par with junk bonds. S&P revised the Spanish government’s credit outlook to negative. Downgrades on bigger fish governments are coming. In fact, Moody is putting the US and UK governments on notice.

Lending at 3.4% for 10 years to the US government is the most mind-boggling stupid investment. Is the market that stupid? Or is it the work of the Federal Reserve?

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Posted in Bonds, Market Observations | 14 Comments »

Hedging against deflation

Monday, October 6th, 2008

The recent nationalisations, collapses and runs on banks in the US and Europe brings a new dimension of economic uncertainty to many people. The last time such things occur in the developed Western world was during the Great Depression in the 1930s. For this current generation of economists, financial analysts and money managers, a credit crisis is something that is supposed to occur only in textbook studies of the past. But recent financial market events brought such abstract history into real life. Suddenly, the idea that cash is no longer safe is a rude surprise for many. If cash is no longer safe, then where else can you hide?

This is what is technically called “deflation.” Deflation is not as simple as just falling prices. It is, as we explained in Will deflation win?,

A falling money supply is the definition of deflation, for which the symptoms will be falling asset prices, which if prolonged enough, will lead to falling consumer prices. But before we go off to celebrate falling prices, remember that this is an evil type of deflation because it is the type that is associated with bad debts, bankruptcies, unemployment, falling income, bank runs and so on.

We recommend that you read our guide, What is inflation and deflation? for more information about this topic.

So, if you are particularly concerned about deflation, how should you protect yourself? As we said before in Should you hold gold or cash in times of deflation?,

You see, the ?cash? that you had deposited in a bank is an asset to you but a liability to the bank. In times of severe economic conditions (e.g. during the Great Depression), can your bank honour its liabilities? If it can?t, then your ?cash? is in grave danger.

The key thing to remember is that as long as your asset is a liability of someone else (e.g. bank), you have a counter-party risk. If your counter-party defaults, your asset is gone. In this evil kind of deflation, counter-party default is the greatest risk to your wealth. Therefore, there is only two ways to protect yourself:

  1. Choose your counter-party wisely.
  2. Keep your wealth in a physical form such that it is nobody else’s liability.

We will first explain point (1). Basically, the only supposedly risk-free counter-party is the government because it has the executive power to tax and print money (note that we used the word “supposedly”- the Russian government defaulted on its bonds in 1998). If you store your wealth in the form of government debt (e.g. Treasury bonds), you will be guaranteed a periodic payment from the government. As we explained before in Measuring the value of an investment,

For example, if you pay $100 for a newly issued 10-year government bond that pays 6% per annum, you are sacrificing $100 of today?s consumption in order to receive $6 per year for the next 10 years. That 6% is your rate of return on your investment. Now, let?s say you decide to sell your government bond to Tom at $90. The rate of return for Tom is 6/90 = 6.67%. Let?s say Tom sells the bond to Dick at $110, the rate of return for him will be 6/110 = 5.45%. Thus, the rate of return of the bond is inverse to the price paid for it.

In times of deflation, government bonds will be so highly sought after that its free market value will rise. Consequently, its yield (rate of return) will fall. On the flip side, government bonds are completely useless during inflation. In times of hyper-inflation, government bonds are as good as toilet paper.

Now, point (2) is already explained in Should you hold gold or cash in times of deflation?. But we would like to add a few more points:

  1. Gold was an excellent hedge during the days of the Great Depression because the US was still under a gold standard. The government would print a specific amount of US dollars to buy the gold that you presented to them. As we quoted Wilhelm R?pk in Which industry?s profitability grew as the Great Depression progressed?, the gold mining industry prospered during the Great Depression because

    So long as there exists at least one country [the US] on a full gold standard, an essential condition of which is freedom to buy gold from or sell gold to the central institution at a fixed price, there is literally an unlimited demand for the commodity at that price. In other words, not only is a minimum price for the product of the industry guaranteed, but there is, besides, no limit to the amount the market will take.

  2. The case for physical gold as a deflation hedge is weakened if the government insures bank deposits. In the US, the FDIC insures up to $100,000 of bank deposits. In Australia, there is NO government deposit insurance.
  3. But if for whatever reason, you (1) distrust the government’s deposit insurance, (2) have more than the amount that is insured by the government, (3) believes that the government will print lots of physical cash to provide for cash withdrawals in a bank run, (4) put a freeze on cash withdrawals to prevent bank runs, (5) government does not insure bank deposits (e.g. Australia), (6) can only trust storing your wealth in tangible form (6) etc, there is still arguably a case for holding gold as a hedge against deflation.
  4. The US government outlawed gold ownership during the Great Depression. It may happen again this time.

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Posted in Bonds, Gold, Investor Education | 14 Comments »

Measuring the value of an investment

Thursday, July 3rd, 2008

If you have not realised already, our previous article, Is the value of an asset its price?, is the beginning of a series explaining the concept of value investing. If you understand value investing, you will then be able to understand the investment philosophy of Warren Buffett, the famous investor who is currently the richest man on earth.

Mind you, value investing is counter-intuitive. It requires that you truly understand the difference between price and value- price is what you pay for and value is what you get. The problem is, the financial market/industry often uses these two words interchangeably, which means that their meaning gets merged in our sub-consciousness. To be an outstanding investor, it is important for you to de-merge the meaning of these two words in your mind. What we are trying to do here is to expand on what Rich Dad, Poor Dad taught about what an asset truly is.

Now, back to the crux of this article…

In the context of investing, when you pay a price for an asset, you are sacrificing current consumption in order to receive the asset’s future cash flow for future consumption.

For example, if you pay $100 for a newly issued 10-year government bond that pays 6% per annum, you are sacrificing $100 of today’s consumption in order to receive $6 per year for the next 10 years. That 6% is your rate of return on your investment. Now, let’s say you decide to sell your government bond to Tom at $90. The rate of return for Tom is 6/90 = 6.67%. Let’s say Tom sells the bond to Dick at $110, the rate of return for him will be 6/110 = 5.45%. Thus, the rate of return of the bond is inverse to the price paid for it.

Next, let’s suppose you pay $100 for a rate of return of 10% per annum. When you receive that $10 at the end of the year, you re-invest it into another asset that also pays 10% rate of return. At the end of the second year, you will receive $11, for which you re-invest it into yet another asset that pays the same rate of return. You do that for all the money that you receive at the end of the year for the next 8 years. What will you have in 10 years time? The answer is $259. In Excel, the formula is “=FV(10%,10,0,-100)”. That $259 is the future value of the $100 at 10% compounding (i.e. you re-invest all returns in the intermediate years) rate of return. The $100 is the present value of the $259.

Now, let’s say you have a business enterprise that is as risk-free as long-term government bonds. Let’s say your business can earn $200 of cash per year for the next 10 years. How much should you sell your business to someone else? The way to calculate it is to add up all the present value of each of the $200 of future cash inflow per year. But which interest rate should you use in your present value calculation? Since your business is as risk-free as government bonds, it should be the rate of return of a long-term government bond based on its current market price. Let’s say that the current market price of 6% government bond is $110 (the price that Dick paid). Then the current rate of return (yield) for that bond is 5.45%. That 5.45% that we use in our present value calculate is called the discount rate (we will explain what discount rate means later). We will put all that calculation on a table:

Discount Rate: 5.45%

Year Cash-flow Present value of cash flow
1 $200.00 $189.66
2 $200.00 $179.86
3 $200.00 $170.57
4 $200.00 $161.75
5 $200.00 $153.39
6 $200.00 $145.46
7 $200.00 $137.94
8 $200.00 $130.81
9 $200.00 $124.05
10 $200.00 $117.64

Total present values=$1511.15.

That is, if you pay $1511.15 for a long term government bond today with a rate of return of 5.45% and re-invest all the cash inflow each year, you will end up with $2569.06 in 10 years time. On the other hand, if you re-invest all the $200 that your business earns each year in the same bond, you will also end up with $2559.06 in 10 years time too. Since your business is as risk-free as long-term government bonds, you are indifferent between the two options. Therefore, the present value of your business is $1511.15. If you can sell your business above the present value of your business, then you are better off doing so.

Now, what if your business is much riskier (as all businesses are) than the government bond? Then the investor who is about to pay for your business will have to demand a higher rate of return. To do so, he has to pay a lower price than $1511.15 (remember, we said above that the “rate of return of the bond is inverse to the price paid for it.”). The lower price reflects the higher rate of return that the investor demands for taking the risk of your business failing. To reflect the higher risk of the business, we turn up the discount rate from 5.45% to, say, 10%. This time, the table will look like this:

Discount Rate: 10%

Year Cash-flow Present value of cash flow
1 $200.00 $181.82
2 $200.00 $165.29
3 $200.00 $150.26
4 $200.00 $136.60
5 $200.00 $124.18
6 $200.00 $112.89
7 $200.00 $102.63
8 $200.00 $93.30
9 $200.00 $84.82
10 $200.00 $77.11

Total present values=$1228.91.

Say, if the investor believes that a higher return of 10% is sufficient to compensate him for the additional risk, then he will be willing to pay not more than $1228.91.

So far, this is the theory behind value investing. In practice, in a world of uncertainty and Black Swans, it is not possible to know the exact amount of future cash flow of any business. Also, risk is not something that we can easily quantify nicely in order to derive a value for the discount rate. That is the ‘art’ of investing.

In the next article, we will explain how inflation is related to the value of your investment.

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Posted in Bonds, Investor Education, Value Investing | No Comments »