# Why did the pension funds pile into the bond market?



## ringledman (26 Jul 2011)

Marc said:


> The bond Market clearly isn't something the amature investor should be playing.


 
I find it amazing that the so called professionals, such as pension funds have been pilling into government bonds these past few years. 

Pilling in right at the end of a 30 year bull market in bond values is a disaster just waiting to happen. 

Inflows intop bonds in now reminiscent of the inflows into equities in 2000. We all know what happened next...


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## Marc (26 Jul 2011)

I don't understand your point.

The bond Market can't disappear overnight all the debt in the world has to be held by someone. Or are you suggesting that we all just walk away from our obligations?

Professional money managers calculate the expected return on a debt obligation by assessing the net present value of the future stream of income payments in the context of the credit worthiness of the issuer and term of the bond.

They have a positive expected return otherwise why would they buy?

Are you suggesting an alternative universe where basic mathematics no longer functions just because bonds have delivered positive returns for the last three decades?


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## Jim2007 (27 Jul 2011)

ringledman said:


> I find it amazing that the so called professionals, such as pension funds have been pilling into government bonds these past few years.
> 
> Pilling in right at the end of a 30 year bull market in bond values is a disaster just waiting to happen.
> 
> Inflows intop bonds in now reminiscent of the inflows into equities in 2000. We all know what happened next...



As Marc said it is not for the amateur! 

You need to understand that very often pension funds are required to hold a certain percentage of their holdings in different asset classes, including bonds and furthermore the fund managers will have a different perspective on how they assess the worth of a particular bond as opposed to your "trading view" of things.  First of all they have a much longer time frame in mind than most investors - think anything from 20 to 40 years and second of all they will be buying the bonds with the intention of holding them to maturity.  These two factors make all the difference - if they can find a deeply discounted bond with a good coupon, they can do very well out of it in the long term, even allowing for the default rate.

Jim.


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## ringledman (27 Jul 2011)

Marc said:


> I don't understand your point.
> 
> The bond Market can't disappear overnight all the debt in the world has to be held by someone. Or are you suggesting that we all just walk away from our obligations?
> 
> ...


 
On the first point, no investment manager should ever base their investment decisions on what is good for the overall bond market. Their decision should be made with the best intention of the fund. 

Secondly, when you state: 'they have a positive expected return otherwise why would they buy?', they are buying because of the herd mentality that affects money managers and trustees as much as or more so than the general public. 

There is nothing 'professional' that sets their investment decisions above all others. 

Bonds have become the in thing for pension funds since they took a hammering after the equity bubble crashed in 2000 on the highest market P/E in recorded history. 

Bonds have replaced equity inflows over the past decade driven largely by pension funds, desperate for a steady return despite the now awful fundamentals for this asset class. 

[broken link removed]

Both pension funds and retail investors are piling into bonds at completely the wrong time. In 1981 when yields hit 16% and inflation liklewise it was the time to buy bonds. 

Now that yields have made multi decade year lows there is only one way to go for yields and that up, with prices down.

The 10 year treasury says it all-

http://finance.yahoo.com/echarts?s=...on;ohlcvalues=0;logscale=off;source=undefined

Pension holders offering to lend to the USA government at 3% for a decade, even if they are going to hold until maturity does not constitue having 'a positive expected return'. 

The risk reward balance for bonds is now skewed significantly to the downside. 

Breaking even for bond holders over the next decade based on the current price of bonds compared to their fundamentals (negative interest rates, debt situation, deficit situation, unfunded liabilities, printy printy, etc) will be near impossible. Holding to maturity will not alter this fact.

The risk/reward for bond holders was skewed significantly to the upside 30 years ago at the start of the current secular bull market. 

Bond yields have recently double bottomed, a classic case that yields are likely to rise from here. 

Contrary to popular belief amongst many on here, asset class returns vary over time dependent upon where the asset class in question is in its secular cycle. 

It is incorrect to believe that buying bonds or be it equities or commodities will return a set x % per annum. Over the very, very long term perhaps but over the investment life of most investors (20-40 years) it is imperative to pay attention to where each asset class is in its secular cycle. The cold hard fact is that secular cycles can be as long as an investor's timeframe.

Bonds are 30 years into a secular BULL market. One of the longest runs in economic history since bottoming in 1981 on multi decade high yields. 

Equities are 1/3 to 1/2 way through a typically lengthy secular BEAR market that commenced in 2000 on the highest P/E in history.

Commodities are 1/3 to 1/2 way through a secular BULL market since bottoming in 1999/00 on inflation adjusted lows, not seen since the great depression.

No doubt pension funds will be pilling into precious metals in a decade's time as the commodity secular bull peaks.


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## ringledman (27 Jul 2011)

Jim2007 said:


> As Marc said it is not for the amateur!
> 
> You need to understand that very often pension funds are required to hold a certain percentage of their holdings in different asset classes, including bonds and furthermore the fund managers will have a different perspective on how they assess the worth of a particular bond as opposed to your "trading view" of things. First of all they have a much longer time frame in mind than most investors - think anything from 20 to 40 years and second of all they will be buying the bonds with the intention of holding them to maturity. These two factors make all the difference - if they can find a deeply discounted bond with a good coupon, they can do very well out of it in the long term, even allowing for the default rate.
> 
> Jim.


 
My investment view is 20-40 years long, hence why I don't invest in bonds for the obvious dire fundamentals that are now present in this asset class.

Pension funds are the party taking a short term view of things on the basis of pressure since 2000 to try and reduce their risk in entirely the wrong manner. 

http://www.thisislondon.co.uk/marke...ension-funds-are-ruined-by-bonds-seduction.do
*



			<H2>Pension funds are ruined by bonds’ seduction

Click to expand...

*


> Whether or not the Greek tragedy ends with that country defaulting on its debts, the mere fact that the possibility exists ought to send a shiver down the spine of pension trustees everywhere.
> 
> This is because for the past 10 years they have been by turns advised, cajoled and bullied into moving their funds out of equities and into government and corporate bonds. They were told to do this to reduce risk.
> 
> ...


</H2>


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## Marc (27 Jul 2011)

On the first point this is actually an equilibrium constaint I was referring to.

Bonds are in positive net supply. You might want to short the bond Market but for you to go short someone else has to be long.

The net positions of everyone adds up to the total bond market.

Let me spell it out really clearly  - there are bonds out there and someone has to own them.

As Jim pointed out some investors (insurance companies for example) aren't worried about certain definitions of risk such as standard deviation.

They are seeking to match assets and liabilities over long periods such as decades.

The bond Market allows them to do this. They are not worried about some random blog post on seeking alpha or zero hedge. 

They actually run real businesses looking after other peoples money in a prudent and fiduciary capacity. What matters is the net present value of a reliable stream of future income payments.

They are much less concerned with the risk of short term losses so do not need to worry so much about short term interest rates.


The things you worry and speculate about are largely irrelevant to professional investors as they should be for most retail investors.


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## Don_08 (27 Jul 2011)

Defined benefit schemes have a pension liability to match against. 

A majority of schemes are closed to new entrants so have a much higher percentage of pensioner liabilities than 10/20 years ago. And also people growing older and pensions paid for longer. 

The perfect match for pensioner liabilities are bonds. Hard to find ones with exact duration, but you are looking for an asset that provides a steady income stream either fixed or linked to inflation ( depending on your pension promise). 

Insurance companies also invest in bonds to provide annuities. 

This is why they ate heavily investing in bonds. Another reason is the introduction of accounting standards where discount rates are prescribed and measured against 10 yr aa rated corporate bonds. If the company are unwilling to have huge volatility on balance sheet then one way to mitigate is invest fully in bonds, as the Boots  UK pension scheme did when FrS17 was introduced. 

It's not all about return with pension funds and insurance companies, the make up of the liabilities are more important.


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## Marc (27 Jul 2011)

My second point follows from the first.

Working out the price of a bond is extremely simple.

The variables which reflect uncertainty over future interest rate inflation and default expectations are all incorporated into the price of bonds today through the mechanism of supply and demand.

In order for any trade to happen both buyer and seller must agree a price.

Prices reflect ALL views including yours.

None of the information you listed above is news. We all know interest rates are low and that they will probably go up. This isnt news future interest rate and inflation expectations are already incorporated into current prices to such an extent that the current yield curve is the best estimation of future yields. 

This has been tested and demonstrated empirically.

To ignore the current yield curve one must be arrogant enough to believe that you know more than all other market participants in the face of evidence that few investors consistently beat the market.

The current yield curve is fairly steep suggesting higher interest rates in the future again this is not news to anyone.

It therefore follows that anyone buying a bond today is already compensated for the interest rate risk.

But the market can't resolve what is unknown so inflation may turn out to be higher than expected but we don't know that for sure now. People confuse risk and uncertainty here.


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## Marc (27 Jul 2011)

Thank you Don

My point exactly


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## ringledman (31 Jul 2011)

Marc said:


> On the first point this is actually an equilibrium constaint I was referring to.
> 
> Bonds are in positive net supply. You might want to short the bond Market but for you to go short someone else has to be long.
> 
> ...


 
Nice academic theory. 

The reason treasuries/gilts are yielding so low and priced so high is due to the huge purchase of this paper conffeti by the Fed or BoE since 2008. 

There is no 'efficient' market in which global investors have priced Western bonds to perfection. At one point 80% were being purchased back by the governments themselves. 

The printers were buying back their own debt. Market distortions on a huge scale. The world's largest ponzi scheme.

There may be value in Irish bonds priced at 60% of their issue but for the rest (USA, UK) none at all. 

UK 10 year gilts are yielding just over 3% with 'official' inflation at 5% (the real, non-hedonic adjusted rate is closer to 7%). The USA's position broadly similar. The PIIGS bond market may have priced in their true value, the rest of the West have not. 

Negative interest rates have been official policy for the past 3 years. This will not change anytime soon. 

Pension funds will most likely get back their capital at significant 'real' losses in a decade's time (bonds are priced for deflation only). 

For those who wish to appreciate the opposing and in my humble opinion, the correct approach to investment valuation, the ever intelligent Montier - 

*'Government Bonds Speculation not Investment'*
http://www.rightsidevalue.com/2009/01/bonds-speculation-not-investment.html

*"From my perspective as a long-term value-orientated investor, bonds simply don’t offer any value. They already price in the US slipping into Japanese-style prolonged deflation. However, they offer no protection at all if (and it may be a big if) the Fed can succeed in reintroducing inflation (what Keynes described as the “euthanasia of the rentier”). There may be a ‘speculative’ case for continuing to hold bonds, but there isn’t an investment case."*

*"I tend to view the world through the lens of a long-term valueorientated absolute-return investor. Albert is often more willing to tolerate momentum driven shorter term positions (believe it or not!). Perhaps it is these differences in approach that have lead to us to adopt different positions on the merits of holding government bonds."*

*"Of course, there maybe a speculative case for buying bonds. If the market is myopic (which is almost always is) then poor short-term economic data, and the arrival of outright deflation could easily see yields dragged even lower. Thus riding the news flow may be a perfectly sensible but nonetheless speculative approach. However, I am an investor not a speculator (as I have proved myself to be appalling at the latter), thus government bonds have no place in my portfolio."*

*"If the alternative scenario comes to pass and the Fed successfully reintroduces inflation (leading to what Keynes so vividly described as the euthanasia of the rentier) then bonds look distinctly poor value, thus the risk is exceptionally high and skewed in one direction. As Jim Grant so elegantly put it government bonds may well end up being 'return free risk' (as opposed to their more normal nomenclature of risk-free return). If yields were to rise from 2% to 4.5% investors would stand to suffer a capital loss of nearly 20%."*

*“An investment operation is one which, upon through analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” -- Benjamin Graham*


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## ringledman (31 Jul 2011)

Marc said:


> The current yield curve is fairly steep suggesting higher interest rates in the future again this is not news to anyone.
> 
> It therefore follows that anyone buying a bond today is already compensated for the interest rate risk.
> 
> But the market can't resolve what is unknown so inflation may turn out to be higher than expected but we don't know that for sure now. People confuse risk and uncertainty here.


 
If inflation rises over the course of the bond's term, the government will not provide current purchaser with any additional income to compensate for the rise in inflation. what will occur is that these bonds issued today will collapse in value and the holders will have two choices - 

1) Hold until maturity and face a 'real' term loss on the capital employed as well as be provided a 'real' term loss on the interest per annum, or 
2) Sell at a huge capital loss before maturity.

The steepening yield curve does nothing for current investors looking at buying government bonds. If current yields reflected this reality and bond prices had collapsed significantly from where they are currently, then sure there may be an 'investment' basis for buying. Currently it is pure 'speculation' that often marks the top of secular bull markets.

As I showed above, investors will not be compensated for inflation then interest rate risk. The UK's 10 year gilt is a classic example. 

3% yield, 5% inflation CURRENTLY. These bonds are priced above their issue price. If markets were 'efficient', their price would fall below 100 in order to raise their yield to compensate the purchaser for the continually rising inflation rate. 

But one example of the flawed investment that most Western government bonds are. The current purchase price are way too high (and hence the yields way too low). With the likely course of inflation as shown by the steepening yield curve, this will simply erode the capital and interest in real terms.

'perfectly priced' market hypothesis simply do not apply to secular bull markets that are about to blow up. The 'new paradigm' of perfectly priced bonds despite every fundamental pointing to the opposing view is the sort of classic talk that comes about at secular highs. 

After a 30 year bull run it is thought near inconceivable that bonds won't do anything but continue to provide a positive return to those punting their or others cash into the asset class. Valuation are thrown out the door. 

Would anyone suggest that Dublin property yielding 2%-3% in 2006 was 'priced to perfection' and a great buy as price is always correct?

All asset classes have their day. Japanese stocks in 1990 on P/Es of 100 times. Dublin Property in 2006 on rental yields of 2%-3%. 

10-20 year Western government bonds in 2011 on yields of 3-4%.

A rising yield curve will only help those investing in the shortest of maturities (less than 2 years). Pension funds buying 10-20 year bonds will most likely face huge future capital losses. Holding to maturity won't help deliver a real return in a steepening yield curve.

As Montier says, bonds are priced for a deflationary spiral only. This may occur but under any other circumstance (average to high inflation) government bonds will face huge capital losses.

Speculate on Irish, Portugal or Greek government bonds (the only Western ones priced to fail) by all means but don't confuse any as an investment. 

Likewise to believe that the rest of the West (France, UK, USA, Australia, etc) bonds are priced correctly and will return to those silly enough to lend to such bankrupt governments is not investing either.

Most government bonds are priced for deflation only. Anything else and its losses all around. Avoid.


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## mainasia (1 Aug 2011)

Marc said:


> On the first point this is actually an equilibrium constaint I was referring to.
> 
> Bonds are in positive net supply. You might want to short the bond Market but for you to go short someone else has to be long.
> 
> ...


 

Extra heap of waffle with my eggs this morning. I can't make head nor tail of your argument here, something about them being 'professionals' and 'knowing what they are doing' so everything is alright so us being mere mortals wouldn't understand anyway.

A classic line - 'there are bonds out there and somebody has got to own them' ?~?

They are not worried about short-term risks such as DEFAULTS which would crush the value of their holdings immediately? Come off it mate.


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## Marc (1 Aug 2011)

There is no point in engaging in such a futile debate.

The simple equilibrium concept that there are no orphan bonds i.e. that all bonds have to be owned by someone is turned into some spurious debate about market timing.

This is an adding up constraint and nothing to do with anyones views or opinions. 

The second point that certain investors seeking to match assets and liabilities through long term positions in the fixed income market is also ignored. Institutional investors invest differently to private investors.

As for the comment about default risk this is dealt with through a diversified portfolio.

Nothing further to add to this pointless thread.


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