Bond prices mean revert after all

Turns out interest rate risk is still a thing

Photo by Jp Valery on Unsplash

Welcome to Known Unknowns, a newsletter that is old-school. It believes that bond prices mean revert and in mark-to-market accounting.

No one saw this one coming

During the financial crisis, it seemed crazy and stupid that all those smart risk managers failed to account for a drop in house prices. This appeared especially stupid when lending standards became lax and house prices soared rapidly. However, perhaps it wasn't entirely crazy, considering that house prices have increased over time.

But bond prices—that's another story. On day one of Fixed Income School, you learn that bond prices mean-revert. While a stock or a house’s price can continue to increase as the company or land becomes more valuable, yields can only go so low. Nobody will pay to lend someone else money, or at least, they won’t pay much to do that. Bond prices can only climb so high before they fall. While some evidence shows that yields trended downward slightly as the world became less risky, they still tended to revert to a mean greater than zero.

It's easy to blame Silicon Valley Bank for being blissfully ignorant of such details. They purchased long-term bonds and mortgage-backed securities when the Fed was doing QE on steroids! Did they expect that to last forever? Well, maybe that was a reasonable assumption, based on the last 15 years, but I digress.

Many of these smaller banks, particularly Silicon Valley, are in trouble because they were particularly exposed to rate risk since their depositors' profit model relied on low rates. So, when rates increased, they needed their money—precisely when their asset values would also plummet. It's terrible risk management. But, to be fair, even the Fed (the FED!) did not anticipate a significant rate rise. Stress tests didn't even consider such a scenario, even as rates were already climbing. Why would we expect bankers in California to be smarter than all-knowing bank regulators?

According to the New York Times, Central Bankers still expect rates to fall back to 2.5%. Why? Because of inequality and an aging population. But how does that work, and what's the mechanism behind it? No good answer, or not one that squares with data before 1985, but we can hope. Sometimes we just want something to be true and for it to be true for politically convenient reasons.

I'm worried that the rising rate environment will reveal where all the bodies are buried. I am even more concerned that markets are pricing in rates to fall back to what they perceive as normal and that the Fed will stop raising rates. But what about high inflation? It’s still a thing. Perhaps tighter credit conditions will bring rates back down to 2%. However, if inflation remains high so will interest rates, then what? Someone is in for an unpleasant surprise.

I believe we can weather higher inflation and a higher-rate economy. This may even lead us to a better place where capital is allocated more efficiently. But surprises are never good, particularly surprises that shouldn't be a surprise. Because, yes, bond prices do mean-revert! I discuss on one of my favorite podcasts (so thrilled they invited me! Even if it took a near financial crisis).

While we are on duration mismatches between assets and liabilities, it's worth noting that you likely have a similar mismatch in your retirement portfolio. However, with rising rates, this time, it's in your favor. This serves as yet another reminder of why hedging is crucial, and hold-to-maturity is all well and good until you need money. And we normally need that money just when asset values are in the toilet.

What's next?

A higher rate environment may cause all sorts of dislocations. I am not sure how it will go down. But it will be interesting days ahead.

I wrote about what higher rates will mean for Silicon Valley few months ago for print City Journal. But in a rare fit of good timing, it just came out last week.

Low rates were what made Silicon Valley Silicon Valley. Other things made it special, the concentration of talent and creativity of course, and the nature of the technology. But cheap and easy capital enabled lots of good and bad innovation. And it allowed investors to make some very large bets on businesses that had no clear plans to make a profit.

The remote possibility of future profits seem like a reasonable gamble in a near-zero rate environment. For pension funds seeking yield, the illiquidity of these investments and their higher promised returns was super compelling. So the money flowed in and rates kept going down. And there were stories of some really dumb businesses getting lots of tax-payer public pension money.

However, those days might be coming to an end. The tech bros are annoying, but I am still rooting for them and for Silicon Valley to remain a center of innovation. Its contributions have been vital to the economy. We need innovation—it's our only hope for growth to pay for everything. Innovation clusters tend to be greater than the sum of their parts; synergy is valuable. A better situation will require lots of humility and some significant markdowns. Good thing public pension funds don’t mark-to-market!

Pension news from abroad

Some big developments for Pension Geeks in Europe. The UK lifted its lifetime allowance on pension savings. Before, there was a limit on how much you could put in your pension account before you faced a tax liability. No more! The government is encouraging more retirement savings. A colleague at Bloomberg argues it's because everyone has their eye on pension assets to do more productive (and socially responsible) things for the economy. However, this plan would involve encouraging less investment in Gilts. Just because we don't have enough turmoil in the fixed-income market. Sometimes, fiscal dominance comes in the form of pension regulations. Good luck with that one.

Macron is bypassing Parliament to increase the French retirement age from 62 to 64. This is a good lesson on what happens if you put off reform. Someone has to make a tough choice, and even when you are spending 14% of the GDP on state pensions, no one will give up anything. It is a good test of whether a society can handle benefit cuts. It does not bode well. The worst problems are the slow-moving and obvious ones.

Still, in this country, we only bypass Congress to give people new entitlements, not cut old ones.

Until next time, Pension Geeks!

Allison