Observations on the current state of government bonds

I just read a money manager commentary about bond markets and was struck by a small table included at the end of the comments.  The table showed current interest rates on federal government bonds with terms of 2 to 30 years for both Canada and the United States.  While I am not an economist, I have done a great deal of reading about economics and thought I would offer a few simple observations of fact for your consideration, without making any recommendations.

The graph below was created from the table of data I mentioned, which was in a commentary from Dynamic Funds, who referenced Bloomberg as the data source.  Data like this is reported on the financial pages of newspapers daily.  The vertical axis shows the interest rate on the bonds and the horizontal axis shows the term of the bond in years.

Observation 1: Short term bond rates are at historical lows.  This is likely due to the low interest rate policy of the Bank of Canada.

Observation 2: Long term bond rates are at historical lows.  This is likely due to the eager buying of bonds by various investors, including central banks.

Observation 3: The lines slope upward and to the right, which is a normal and rational shape.  It is logical that long term rates should be higher than short term rates due to the uncertainty associated with the time value of money.

Observation 4: The 12-month Canadian consumer price index (CPI) has been between 1.2% and 3.7% in the last couple of years.  The last reported number is 1.2%.  Two and five year bond rates are presently below the inflation rate and thus have what are known as negative real returns.  This means the money in those bonds is steadily losing purchasing power.  To phrase this another way, many bond investors are apparently content to absorb a relatively steady loss of value rather than invest in other assets that have a higher perceived risk of loss, such as equities.  As some economists put it: inflation is a transfer of value from lenders to borrowers; from bond investors to bond issuers.  This transfer is very apparent in these days of negative real returns.

Observation 5: In many world equity markets, dividend payout rates are significantly higher than bond interest rates.  In this case, the owners of companies are paid a higher income AND have the rational expectation of rising income over the years.

Observation 6: Many governments have massive and rapidly growing debts and this represents a real risk to the financial security of their countries.  Since they have to pay interest on the bonds they issue, they have implemented a variety of policies and controls to keep interest rates below what we would likely see in a free financial marketplace.

Observation 7: Interest rates on Canadian and U.S. bonds have been falling for thirty years, since the peak in the early 1980’s.  Back then, rates were around 18% for long term debt and in the 20’s for short term debt.  The past 30 years have thus been a remarkably and unrepeatedly good time for bond investors since bonds perform best in times of falling interest rates.

Observation 8: It is most likely that interest rates will be stable to rising for a long time to come.  A rational expectation during this next phase is for low to negative returns from long term government bonds.

Observation 9: Since most bonds are issued as a contract for a fixed number of dollars and the interest payments are also fixed, if inflation rises then these bond holders will suffer a progressive loss of purchasing power, likely never to be recovered since inflation is rarely negative.

Observation 10: Since equity shares and their dividends represent claims on the real assets of society and not just on fixed dollar amounts, over time they rise with inflation and thus protect purchasing power.

Observation 11: Such low interest rates are making it very difficult for insurance companies since they rely on bonds to protect and grow the reserves they keep to cover future claims.

Observation 12: Low interest rates are causing many pension plans to show severe actuarial shortfalls, meaning they do not expect to have enough money to pay out future employee retirement pensions.  If you are in a defined benefit pension plan, you may want to read the last annual report on the funding status of the plan and you should expect to pay higher contribution rates and maybe expect lower benefits in the future.  For a more detailed look at this, read Pension Ponzi.