What Does A Bond Crash Look Like?

What Does A Bond Crash Look Like? Swiss government debt maturing in almost 50 years yields around zero. Unilever, the Anglo-Dutch consumer products maker, has securities due in 2020 yielding negative 0.19 per cent. Five years ago, these securities would have seemed impossible.

What are the real consequences for this nonsense? Investors, mostly institutions, are sitting on a mountain of capital gains that cannot be realized. Someone, somewhere, is going to sustain absolutely monstrous losses, no matter what else happens.

Let's take, as an example, the long-term German bunds issued four years ago which are now trading at 200% of par thanks to the collapse in interest rates. Historically, the yield in the 10-year German Government Bond reached an all-time high of 10.80 in September of 1981 and a record low of -0.19 in July of 2016. The chart shows just how precipitous the decline in rates has been:

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Here is the intractable problem, as pointed out by David Stockman. Even if the financial system somehow survives the current mayhem, the German government will never pay back more than 100 cents on the dollar. This means there are guaranteed massive losses to come. At some point, there will be a multi-trillion dollar bond implosion as speculators and bond fund managers scramble to cash-in their capital gains or avoid catastrophic losses.

The Johnny-come-lately bond managers who today are buying trillions of dollars of bonds at a premium to par will face massive write-downs. Consider the 4% coupon Italian bonds that have traded up to yield just 1.2% owing to Mario Draghi's $90 billion per month asset-buying spree. Returning to a yield of 4%, the loss is more than 70%. The Italian banking system is stuffed with paper like this. Already weak balance sheets depend on current valuations.

When? Certainly at the first sign that global bond markets are breaking down. Perhaps when a surprise inflation report exceeds expectations? Maybe when regulators or investors start asking for risk adjusted valuations from banks and bond funds? It could be sparked by growing opposition to ECB or BOJ asset purchases. The Fed could finally look serious about raising interest rates, drawing money out of other markets. Or the buyers of negative yielding paper are finally exhausted, a big seller shows up and the only bid is from the central bank. The implosion could happen at any time.

All the unrealizable gains generated by ridiculously low interest rates are booked somewhere and they undoubtedly have been used to finance or prop up other positions. The potential losses are incalculable.

Central bank policies have inflated an enormous bond bubble which has created extraordinarily fragility at the heart of our financial markets. Is there any way to let the air out slowly? We don't think so. Once the market turns, we think the collapse will be stunningly swift. History is very clear: market forces have always overwhelmed central bank attempts to manipulate them. The only thing holding the system together is the misplaced faith that it will continue.

Gold ownership may be the only effective protection, in our view.

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