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.
The U.S. insurance industry’s high-yield bond exposure of almost $300 billion at year-end 2021 is the highest BACV reported over the last decade. (See Chart 2.) From 2012 to 2021 , high-yield bond exposure increased approximately 42% while total bond exposure grew approximately 34% as insurance companies sought higher relative yields offered by high-yield bonds, among other asset classes, amid the low interest rate environment of the past decade. In addition, most recently, credit quality deterioration from the impact of the COVID-19 pandemic resulted in some migration of the industry’s investment grade bond exposure into high-yield territory, particularly in 2020.
On a percentage basis, high-yield exposure accounted for 6% of total bonds at year-end 2021, the second highest point over the 10 years ending 2021. While exposure declined modestly from 6.1% at year-end 2020, as a percentage of total bonds, it remains elevated relative to the last 10 years. The most recent period when U.S. insurers’ high-yield-bond exposure exceeded 6% of total bonds was in 2009 during the financial crisis when it reached 6.3%
Author(s): Michele Wong
Publication Date: 13 Oct 2022
Publication Site: NAIC Capital Markets Special Report
Analysts attributed the popularity of bond funds — which do not include money-market holdings — to concerns about lofty stock valuations and an ageing population’s need for steady income during retirement.
“Financial advisers follow asset allocation models and portfolio rebalancing and demographics are strong trends,” said Shelly Antoniewicz, ICI senior director of financial and industry research. “The cumulative flow to bond funds lines up nicely with the percentage of the population over 65 years.”
Historically, bond yields have not been very good at predicting inflation.
In the last 70 years, bond yields rarely rose ahead of inflation, going up only after inflation takes hold. One study indicated that past inflation trends were a better predictor of bond rates than what future inflation turned out to be.
Does this mean bond traders are wrong? Not necessarily. It may just reflect that inflation is unpredictable and bond traders don’t know any more about the future than the rest of us. All they have is the past data and current prices to make their predictions, too. So when inflation suddenly spikes — as it has in the past — bond traders are as surprised as everyone else.
The sharp increase this month in U.S. government-bond yields is pressuring the stock market and forcing investors to more seriously confront the implications of rising interest rates.
The lift in yields largely reflects investor expectations of a strong economic recovery. However, the collateral damage could include higher borrowing costs for businesses, more options for investors who had seen few alternatives to stocks and less favorable valuation models for some hot technology shares, investors and analysts said.
As of Friday [Feb 19], the yield on the benchmark 10-year U.S. Treasury note stood at 1.344%, up from 1.157% just five trading sessions earlier and roughly 0.9% at the start of the year.
Does expansionary monetary policy drive up prices of risky assets? Or, do investors interpret monetary policy easing as a signal that economic fundamentals are weaker than they previously believed, prompting riskier asset prices to fall? We test these competing hypotheses within the U.S. corporate bond market and find evidence strongly in favor of the second explanation—known as the “Fed information effect”. Following an unanticipated monetary policy tightening (easing), returns on corporate bonds with higher credit risk outperform (underperform). We conclude that monetary policy surprises are predominantly interpreted by market participants as signaling information about the state of the economy.