Bond market turns treacherous

By Neville Bennett

Friday 1st August 2003

The Reserve Bank last week reduced interest rates and promised more could follow if justified. The decision to cut was widely supported but much negative comment suggested deeper cuts were necessary.

Many critics assume high interest rates are driving the dollar too high, thereby reducing export income and employment.

A minority believe lowering interest rates will merely add fuel to the property market, which clearly has bubble properties.

Most of these comments were made with little reference to the international context. Thus it has escaped notice the Reserve Bank is loosening rates when international rates are tightening.

International bond markets are in a state of convolution, and given the magnitude of the money involved, the issue demands attention.

The Reserve Bank and the US Federal Reserve have both cut short-term interest rates. Governments can dictate short-term rates but fortunately cannot seriously affect long-term rates.

The market decides long-term rates and the market is screaming its insecurities. It is pushing up yields in 10-year bonds at a remarkable rate.

US bond rates have increased at break-neck speed, bushwhacking some investors.

Yields on the 10-year term have appreciated 100 points in a month. The yield has shifted from 3.07% on June 16 to a 4.19%. This has shifted US long-term mortgage rates to 6.0%, rising from only 5.2% in June, which was the lowest rate in half a century.

As the price of bonds moves down when interest rates rise, there is a lot of grief among fixed-term investors. They have suffered a loss of capital values, and also wonder if they should cut their losses.

This nervousness has caused $US40 billion to be shifted out of bond funds. The seriousness of this leakage can hardly be exaggerated, as the bonds are supposed to be safe. However, investors remember the catastrophe of 1994 when many bondholders lost their shirts. The 2003 situation could be more treacherous.

But there is a difference between bonds and equities. When equity prices fall, investors wonder if their investment will prove valueless. They could panic, sell and cut their losses.

But bonds often have a respectable credit rating, and the investor can expect to recoup the bonds' value at maturity, plus the compound rate of interest. If an equity investor sits tight, he can lose everything; a bondholder gets his money back plus interest.

The trouble is that most of the US investors who are exposed to the bond market do not have bonds but are exposed to the bond market through mutual funds. This is a mammoth funding arrangement it is the equivalent of a third of US debt ownership and it must be the biggest single investment category in the world.

This has become volatile. The investor no longer sits and waits for returns. Either he chases the margins (trying to get the best return) or plays super safe by laddering. Both approaches make turnover volatile.

Chasing returns means the daily trading volume in municipal bonds alone (small beer compared to treasury and business paper) rose to $US11.8 billion in the first quarter of 2003.

Laddering, or arranging maturities in a time series such as two-year, five-year and seven-year, also affects volatility.

But what makes the situation more explosive is a rapid turn of events. Market yields are rising at frightening speed. This is reducing capital values of investments, often held by people who could be regarded as inexperienced fixed-interest investors.

These people are often refugees in that they have cashed up in the equity market after great disappointment. In the short-term at least, many feel they have jumped out of the frying pan into the fire.

The long-term bond market has a tremendous impact on the US mortgage market. New Zealand's market is responsive to short-term or floating interest rates: this limits our understanding of the US market where a 30-year term is often the norm.

Adjustable rate mortgages are only 15% of the market. The huge Freddie Mac, for example, quotes a 30-year fixed-term rate as its benchmark. Last week this jumped from 5.67% to 5.94%, the largest one-week increase in five years. The rate has risen nearly 0.75% since June 13, when rates bottomed at 5.21%.

One potential danger is the adequacy of risk-management precautions in dealing with refinancing. As interest rates have fallen, many homeowners have refinanced existing mortgages or have realised some equity in their homes.

The refinancing industry alone is raising an unbelievable $US4 trillion in new debt. Refinancing is usually about 70% of mortgage activity.

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