Like the Baroque, finance is the realm of trompe-l'oeil and cognitive dissonances. No one complains too much if his portfolio yields one percent with inflation at two. We all complain a lot if the portfolio loses half a point with zero inflation.
This also happens in real life. You accept a year without salary increases even if there is inflation of two per cent. It feels very unfair to see wages cut by one percent with inflation at zero. Keynes, thinking more like a psychologist than an economist, said that it was necessary to leverage these cognitive distortions and promote moderate but systematic inflation to redistribute wealth and to allow, if necessary, to lower wages without creating too much friction .
All 'monetary/real optical illusion the bond world adds more of its own. It must have happened to many, in recent years, to notice that a 120 bond with a 5 coupon and a 4-year maturity sounded much better than a 100 bond with a zero coupon and the same maturity (we are not counting compound interest for simplicity).
The optical illusion became even more irresistible if the bond was bought with a coupon of 5 in issue, i.e. at 100. In this case, seeing it risen to 120, one had the sensation of having pocketed a capital gain and, at the time himself, that he is still entitled to a nice 5% coupon. The thought that 120 would, over time, return to 100 was either deferred to a vague and distant future or removed altogether. Eat the cake and still own it, is the saying in English. Double counting, we say in Italian.
This pleasant illusion turns into a very unpleasant (albeit equally illusory) perception the moment instead of continuing to fall, market rates begin to rise. If I buy a 4-year bond at 100 with a one percent coupon, I know at the outset that I will have 104 at maturity. However, if after my purchase market rates rise, my bond will go down in price and I will see it at the end of the year , let's say, at 98. Of course, I will have collected the coupon of one, but the overall result will be 99 and I will therefore have the feeling of having lost one percent, moreover on an instrument, the bond, which I expected to be stable it's safe. I will then call my banker and, showing all my disappointment, I will ask him to account for this loss. He will reply telling me to be calm, because at the end of the life of the bond no one will take my 104 from me (the same 104 that seemed interesting to me when I bought it), but I will remain the same with a bad taste in my mouth.
The finding that bonds can go down in price it is known to those who followed the markets in the seventies (or to those who studied those years) but it is new, at least in emotional terms, for many of those who came after. Of course, in the almost forty years of bond hikes from 1981 to today there have been moments of downturn, typically in two phases of the cycle, the one in which rates begin to rise significantly (i.e. in the middle or three quarters of the cycle) and in the final phase.
In the first of these phases long and emerging bonds usually fall, in the second the shorter ones are hit. The damage produced by these downturns in these forty years has been particularly significant for institutional investors, accustomed to operating on leverage. Little did the general public notice, as three- to five-year yields were always high enough (until 2009) not to encourage significant exposure to long, emerging and credit maturities.
After 2009, however, the lack of returns on the short and safe prompted the general public to venture into the long and uncertain. Today's shock is therefore double. On the one hand, the abrupt detoxification due to the lack of those bond capital gains that by now seemed an acquired right, on the other, the greater exposure to the long-term and uncertain, in particular to emerging markets.
Losses on bonds for the period lead many investors to wonder if, from now on, cash is not better, on which at least one does not lose. The long answer to this question is that it depends on the cases. Before going into detail, it should be remembered that up to now the banks have not passed on the negative interest rates on liquidity to customers' deposits in euro. In the future, probably, this will no longer be the case, especially if, in the next recession, rates will drop well below zero. It should also be considered that a deposit is a loan to the bank made in times of bail-in.
On the other hand, to the detriment of bonds, it should be remembered that the spread between bids and offers has widened in recent years. Before 2008, market makers held 10 percent of the entire bond market in inventory. It was a huge amount, obviously debt financed, providing intermediaries with a large positive carry and clients with a very fluid and liquid market. After 2008, regulators increasingly restricted bond inventory space, which made it more difficult and expensive to buy and sell bonds. The expected liquidity shortfall over the next few years will make things even worse.
That said, what the time horizon of the bond buyer is decisive or decides to remain liquid. If it's short, cash is worth it, if it's long, bonds are worth it. However low the yields are, over the years they make a difference. The objection that the price to bear for these returns is volatility and the risk of ending up trapped with low coupons if rates rise can be answered by suggesting inflation-indexed securities, which are less volatile (if they are not too long) and capable to adjust to rising rates.
The short answer to the cash/bond alternative right now is that bonds might still pay off. The end-of-cycle narrative circulates almost exclusively on the market. Rates will rise linearly until economies can no longer take it and go into recession. Jamie Dimon has been making a lot of noise these days saying he's ready for 4 percent rates.
However, there is another minority but suggestive thesis put forward by David Zervos. This isn't necessarily the pre-recession bond pullback, he says, but it could be what typically reacts to the first round of rate hikes.. Once the rates and curve have been adapted to the new reality, we can even stop (or in any case slow down) especially if the rise that has taken place so far brings with it a strengthening of the dollar. The next phase could therefore be one of stabilization and would not preclude the possibility of a prolongation of the expansion and a slow equity appreciation.
In conclusion, a particularly happy and atypical historical phase has come to an end for bonds, but this does not necessarily mean that a markedly negative one has opened up. As Bill Gross has always said, investors should be happy when rates go up.
