Dr. Sherry Jarrell

S&P Ratings - They either mean something or they don't

You cannot have it both ways. Either the bond credit ratings mean something, or they don't.  Public officials cannot point to the AAA ratings as evidence of good policy, then lambast them as "inaccurate" and "flawed" when they drop to AA+....or below.  

It is a fact that the ratings agency does not originate information; it simply gathers and interprets data that are publicly available to all of us.   The rating itself, however, is unique in that it summarizes a particular agency's forecast of how likely the US government is to repay its debt and sustain its borrowing needs.  

Don't get me wrong -- there is a LOT of information out there about the risk-adjusted rate of return on US debt to be digested.  But we don't have to re-examine it from the ground up -- we need only look at the marginal changes, the most recent developments, the direction of change, to update our expectations, and -- in my view -- to understand easily why S&P downgraded the debt.  

I think most of us realize that all government spending is financed by the private economy but I'm not as sure that everyone realizes that the return on government debt is also enabled by the productivity of the private economy.   The more productive the private economy, the higher rate of real return we can afford to pay on U.S. debt, and the more willing others are to buy our debt.  Being able to generate a return on debt is a good thing -- it's a sign of a healthy economy.   

Then there is the other side of the equation: the required return on debt from the point of view of the lender. The lender assesses the risk (or likelihood or uncertainty) that they will get their money back (and that the "money" is worth the same per dollar....so we are ignoring inflation just to simplify things).   The less certain they are, the higher the return they are going to demand before they buy the debt.  This required rate of return is a cost to the economy -- a higher cost eats away at profits, and makes the economy less productive, less able to reinvest, employ capital and labor, and grow.  

In the simplest terms, government spending is supported first by taxes and then, when those run out, by borrowing.  The debt ceiling debate made it clear that Washington was unwilling or unable to reduce or curtail government spending, which was on its way to starving the private economy of the sufficient earnings, liquidity and financing to continue to be productive.  The wealth creation capacity of the private economy is vast and impressive and has somehow miraculously employed labor and capital and supported AAA rating returns on government debt for a very long time, but it's not limitless.  

No, the ratings do not originate information. They simply publicly confirmed what many of us who understand and respect what private enterprise does day in and day out saw coming:  the current level of government spending is unsustainable. The private economy cannot take much more of the oppression and costs imposed by government policy, taxes, fees, regulations and -- perhaps the most troubling and insidous of all -- the public denigration and disparagement of the private economy, Wall Street and capitalism by our President.

 

It will be very interesting to see if this was a surprise to the markets.  

Should you Invest in U.S. bonds? Part 3

This is part 3 of a multipart series on the factors that drive U.S. and foreign bond prices and yields.

The yield on a bond is made up of several components. Some think of the return on a bond as the sum of the risk-free rate of interest (how impatient we are to get our money back, or how much we need to be compensated to delay consumption) and a risk premium (the additional return we require to compensate us for the risk of default, the risk the bond will be called, the risk of inflation reducing the purchase power of the repaid dollars, and many other sources of risk as outlined in the most recent article in this series).

Another useful way of thinking of the return on a bond is as the sum of the real rate of interest and the expected rate of inflation.  But what is the real rate of interest?  We never actually observe that rate, unless of course the inflation rate is zero and then the real rate is just the nominal rate set in the market.

It is useful, however, to think about what drives the ability of a company to generate a real rate of return to lenders, for this is essence of capitalism and risk-taking and creating economic value and growth.

Bond traders

A firm’s asset cash flows support the real returns to its lenders – all kinds of lenders (debt, equity, hybrid, and derivative security holders). A firm will want to borrow more, and is willing to pay a higher interest rate for those funds, the more profitable are the projects they want to undertake, or the greater the number of profitable projects. Profitability, in turn, is determined by the relationship between demand and supply:  how much does society value a good or service, and how many resources does the business use in producing the good or service.  As the marginal productivity or efficiency of a business goes up, it can afford to profitably fund more projects.  So the core driver of the real return on bonds is the strength of the underlying economic activity of the private economy.

Or, when viewed from the investor’s side, note that an investor will purchase a bond, or lend money to a company, if they expect to earn a return sufficient to compensate them, first, for delaying consumption and, second, for bearing the various sources of risk or uncertainty associated with the bond’s cash flows or return.

Bond’s in a weak or faltering economy will generate a lower return to lenders than bonds in a strong economy, absent inflation or any other material changes in the purchasing power of the currency.  Weak demand for goods and services means weak demand for financial capital which means low rates of return on financial capital.

The policies of the government can increase the borrowing costs of private industry.  Fiscal policy that increases taxes reduces the profitability of projects and undermines the ability of companies to pay coupons and repay principal.  Monetary policy that increases the money supply may lead to inflation, which also increases the cost of borrowing and reduces economic activity.

Lastly, and of the greatest concern of late, is the level of borrowing by the U.S. government.   Debt levels are at record highs, with no relief in sight. The AAA rating of U.S. debt is reportedly in jeopardy (Chicago Tribune editorial).  Both existing and new lenders worry about the ability of the U.S. government to repay. Yes, the can simply roll over existing debt by raising taxes or creating money to retire old debt and replace it with new, but the interest rate required by new lenders goes up as the ability of the private economy to sustain tax revenues falls and the risk of inflation rises (Moody's explains U.S. bond rating).

Both factors are in play now: an anemic economy with little hope that this administration will undertake policies that support business, and a ballooning money supply and weak dollar that undermine the purchasing power of the returns to lenders.  The returns to U.S. debt may still be healthy relative to those one can earn in other countries, but the spread is shrinking. The private economy remains fundamentally strong, thanks to the work ethic of the American people and the profit motive of the capitalistic system, but the policies of the U.S. government are straining those resources.

Should You Invest in U.S. Bonds? Part 2

Sources and types of risk in U.S. and other bonds.

This is part 2 of a multipart series on the factors that drive U.S. and foreign bond prices and yields.

Recall that a bond’s price is the present value of its coupons (if any) and face value (or principal or par value).  Let’s keep things simple for now and consider a zero-coupon or “discount” bond.

One thing of interest to note first: As we move forward in time from the issue date toward the maturity date, and the number of periods between now and the maturity date falls, the price of a discount bond rises toward the face value of the bond, even with no changes in the interest rate.  At maturity, the price of the bond equals the face value. Only unexpected changes in the effective return on a bond can change the natural upward progression of its price toward face value between the issue and maturity dates.

This example makes clear that the (annual) yield on a bond, simply put, is driven by the difference between the price paid for the bond and the cash flows it generates, that is, the difference between “dollars out” today and “dollars in” later.

The “dollars out” are known because we pay a given price for the bond today.  The “dollars in,” consisting of coupons (if any) and the face value of the bond, are also “known” in that they are specified in a contract at the time the bond is issued.  The realized value of these dollar returns is, however, subject to many different sources of uncertainty or risk. A short list includes:

Interest rate risk: how sensitive the price of the bond is to changes in interest rates over the life of the bond.  Interest rate risk is higher for bonds with a longer maturity (more time for the unexpected to happen), a lower coupon (more of the value of the bond is tied up in the principal), and a lower initial yield (a 1 percentage point change in interest rates represents a higher relative change in low yields).  Floating-rate bonds have much lower, though not zero, interest rate risk.

Reinvestment rate risk:  Bondholders may reinvest their coupons at the then-prevailing rate of interest. As those market rates of interest change, the return on reinvested coupons becomes less certain. Reinvestment risk is higher the higher the coupons, the more frequently the coupons are paid, and the longer the maturity of the bond.

Bankruptcy Court: Destination for issuers in default

Credit or default risk:  the risk that the issuer will default on the payments of the bond, which reduces the number of “dollars in” relative to price paid, lowering the earned yield on the bond.   Credit risk is frequently measured as the credit spread over like Treasuries, which are assumed to have zero credit risk.  Credit risk includes downgrade risk, where a credit rating agency lowers the rating on an issuer as their ability to repay the debt is brought into question.

Call risk:  the risk that a callable bond will be called by the issuer. Since a bond is typically called only when it’s in the best interest of the issuer, the call feature is systematically harmful to the bondholder.  Prepayment risk reverses these risks:  prepayment is good for the bondholder, and bad for the issuer.

Exchange rate risk (that the value of the repaid currency will be lower), inflation risk (that the value of the repaid dollar will be lower), and event risk (natural disasters, corporate restructurings, regulatory changes, sovereign or political changes) round out the list of broad types of risks that drive bond yields.

Next time: why the types and level of risks are so difficult to measure and predict.

by Sherry Jarrell

Should you invest in U.S. bonds?

Could the U.S. government default on its bonds?

I’ve been asked many times over the years for advice on investing. “What is the market going to do?” “Should I be invested in stocks or bonds?” And, especially in the last few weeks, “Should I hold U.S. or foreign government bonds?”

A U.S. treasury bill

Those are some good questions!  The answers are not as "good."  The factors that drive the yields on treasury bills and bonds are complex and, despite Ben Bernanke’s pronouncements to the contrary, less well understood than stock returns.  And, although I don’t have a crystal ball, I can at least frame an answer to these questions here.  I will come back to expand on this topic over time, as markets, economies, and world events evolve.

The return on both bonds and stocks is measured as the percent change between the market price today, and the cash flows received later.  The cash flows of a bond, namely coupon payments and principal, are specified in a contract; if they are not paid, the issuer is in default, and the bondholder has the right to take them to court.  The cash flows on stock, dividends and capital gains, are residual; they are discretionary, and are paid out only after debt payments and other obligations are paid.  For this reason, the returns on bonds are considered to be less risky than those on stocks, and as a result the nominal yields on bonds tend to be lower than those of stocks.    

There is an important distinction between the nature of the returns on bonds and those on stocks. With bonds, the future cash flows are known: the bond’s yield is determined simultaneously with the bond’s price. Once a bond is issued, only changes in interest rates (yield, risk) drive unexpected changes in its price.  Stock prices, on the other hand, fluctuate as either risk or residual cash flows change.  As a result, changes in a bond’s price, hypothetically at least, are a much cleaner indicator of the market’s expectations of future market rates of interest than movements in a stock’s price.

The information about future interest rates that is revealed by changes in the bond’s price is distorted somewhat by the fact that bonds are less frequently traded than stocks, so the price data on bonds is less comprehensive and complete. In addition, the reported price data that form the basis of bond yield models often diverge from actual market-clearing prices, so that bond pricing models may not describe actual market behavior. Lastly, there is such a tremendous volume of economic and policy information, some of it conflicting, that is crammed into this one variable, the bond price, that it is very difficult to isolate what bond price's say about any one factor, like the term structure of interest rates. 

Next time: Sources and types of risk in U.S. and other bond prices.