Available data isn’t great and I’ve made the odd assumption. Very roughly, though, there are the same number of anglers in Europe as participants in organised football. The US has five times the number of fishermen as soccer players.
Yet coverage of football eclipses angling — even in the US, which hosts the World Cup next month. The reason? While fishing is the more popular sport, one ball is easier to follow than hundreds of different types of bream, sinkers and hooks.
Ditto with equities and bonds. Despite markets of a similarish size, the former receives 95 per cent of the world’s attention. Open a newspaper, turn on CNBC or surf the interweb, it’s stocks, stocks, stocks.
And like drinking beer all day in a boat, it’s not as if bonds aren’t a crucial part of life. Their prices determine mortgage rates, pension values, banking system stability and government financing costs (and thus what you pay in tax).
The trouble is, almost nobody understands bonds — including professionals who have worked in finance for decades. Next time you speak to your adviser, ask them to explain carry, basis risk, term premia and convexity.
What chance do retail investors have? Only two-thirds of us even realise we would lose money if the interest rate on our savings were 1 per cent while inflation was 2 per cent, according to a famous survey of financial literacy in the US.
Frightening stuff in a week when bond markets (integral to any discussion of interest rates and inflation) were front-page news for a change. You may have read that long-term yields have reached multi-decade highs in many places around the globe.
This means bond prices are falling. Indeed, this inverse relationship in itself is enough to baffle most of us. Only last night I had to explain the concept again to my clever mum after her gilts had taken a pummelling.
And that’s the easy bit. The nuts and bolts of bond pricing are Chinese algebra in comparison. It’s beyond me. But I can see the simple mistakes other ignoramuses make. And five have popped up repeatedly as the bond rout intensified.
The first is believing that bond markets are omniscient or at least smarter than equity markets. A common refrain: “Bond prices reflect the dangers ahead. Stocks have to wake up.” British politicians are literally scared of bond investors.
Maybe it’s because bonds are complicated — like maths teachers seeming brainier than geography teachers. But bond managers are as prone to underperformance as equity ones. More than 80 per cent of European bond funds have lagged behind their indices over 20 years, according to Lipper LSEG data. The underperformance of managers of Asian funds is worse.
Related to this is the error of comparing bond yields with earnings yields. It is true that the latter for the S&P 500 now trails the 10-year Treasury yield to an extent not seen since 2002. But as I’ve written before, any relationship is meaningless in theory as well as in practice.
It’s apples and pears. Bond coupons are fixed while earnings (and dividends) rise and fall with inflation. They shouldn’t relate to each other — and they don’t. Look at a long-run chart. No correlation whatsoever.
The next fallacy you hear everywhere these days is that rising 30-year yields are due to bond investors losing faith in cash-strapped nations being able to reduce their sizeable debt-to-output ratios.
Sure, government borrowing can spook short- and medium-term bond prices. At multi-decade maturities, however, it’s really only expectations of inflation far into the future (plus a risk premium for parting with your money for half of your life) that matter.
Debt levels only have a minor influence on this premium for countries with credible central banks: Investors want to know if debts will ultimately be inflated away, monetised, defaulted on, or absorbed. But expected inflation is the dominant driver of yields.
Of course, current inflation shapes inflation expectations. That is why bonds sold off last Friday after US consumer prices for April were higher than expected. It’s also why — if you reckon as I do that inflation will moderate when the Iran conflict ends — you should be buying bonds.
How do you track long-run inflation expectations, then? Not by blindly quoting the five-year, five-year forward inflation rate (an estimate of the average rate of inflation over five years in five years’ time) as everyone does, that’s for sure — my fourth pet peeve. Only surveys reveal what investors think inflation a decade down the road will be.
Using implied yields or the swap market will not give you a pure reading for inflation expectations because these are traded asset prices — with all that entails. So into the mix goes supply and demand, technicals, liquidity conditions, and other distortions such as quantitative easing. It’s the same reason why oil futures aren’t an indication of future oil prices.
Thus five-year, five-year data has limited predictive power over such long time horizons, a European Central Bank paper concluded. And even over one and two years, surveys are just as accurate. At best the metric hints at how good a job policymakers are doing in anchoring expectations. Nothing more.
I remember, for example, that when the five-year, five-year rate was going bananas in the financial crisis and during the Eurozone sovereign debt meltdown, long-run inflation expectations didn’t move much. Conversely, it underreacted post-Covid.
The long list of complex factors that influence bond prices is also why inflation-linked bonds are not a substitute for measuring real yields. Conflating the two is the fifth misconception that drives me potty.
This one is particularly harmful as real yields are the one true economy-wide indicator of the cost of borrowing and lending. They have nothing to do with pension fund demand, liability matching, liquidity and inflation-risk premia and all other stuff that goes into the pricing of Treasury Inflation-Protected Securities or Linkers.
Avoid these five traps if you can. Or do as I do and admit defeat on bonds from the start.
The author is a former portfolio manager. Email: [email protected]