The Red Pill

Wall Street traders (bless their dark souls) hold that there are two kinds of personalities – the stock type and the bond type. Stock guys are thought to be optimists while bond people have a gloomy reputation. There must be some truth to this because in ten years I have not met a bond manager with a sunny disposition.

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Thankfully, Morpheus’s medication did not offer Neo a glimpse of the bond matrix. That’s one rabbit hole even he couldn’t have got out of easily.

Luckily, most of us are stock-people. We extol and defend our favorite stocks to the point of irrationality. In the meantime, it is forgotten that the bond market dominates the economy in a way that stocks never have and never will.

Bonds are about lending money, pure and simple. You may not be used to thinking of yourself as a lender, but you don’t need to do much to be one. The mere act of depositing money in a bank is enough. Your deposits are loans to the bank and your “bank balance” is just a pile of IOUs that the bank owes you in return. And when you spend the money in your checking account, what really happens is IOUs being moved around e.g. when your rent check is deposited, some of your IOUs are transferred to your landlord’s account.

What we are so used to calling “money” is mostly just IOUs from some bank or the other. IOUs are assets.

Lending is remarkable in another way – it creates more money out of thin air. Here’s an example: Say Mary lends John $1000 which he agrees to repay through equal installments of $200 over 5 months plus $100/month in interest. This IOU is now an asset for Mary because she expects to be paid from it. How much is the asset worth? In the best case scenario, where John pays everything on time, the asset will yield $1500. But if John defaults it could yield much less. The problem is not straightforward: unless Mary is a Wall Street quant she will not find it easy to value the loan. But, being smart, she calls the bond desk at a valuation agency such as Interactive Data (aka ICE), their analysts crank some math levers, and within an hour she is told the IOU is worth $1200. Interactive Data’s blessings have now made the loan marketable. Mary now sells John’s IOU to a bank which simply puts the IOU on its balance sheet (as an asset) and credits Mary’s account with $1200 in bank IOUs. John’s IOU has now become regular money for her! She can spend it however she wants. But recall that John still has the original $1000. So, Mary and John now have a total of $2200 in money, while originally they had just $1000. Mary created an extra $1200 in the economy simply by lending money to John! (Of course, John now owes the bank instead of Mary. Lending creates money at the expense of creating liabilities.)

This can go on. Our friend John lends that $1000 to Robert (say) and creates another IOU, has it valued by an agency, and sells it to yet another bank in exchange for a credit to his account. We have yet another piece of money in the system. Repetitive lending and the banking system together increase the money supply in the economy.

Physical cash i.e. notes and coins are a small part of what we call “money” in this world. More than 90% of money is just bank IOUs backed by all sorts of lending! Welcome to the credit-based economy. It makes some people nervous – it may well be making you nervous right now.

Virtual as it feels, this system has worked well for the most part since the 1980s. But it depends critically on the ability to value and transfer the IOUs, as Mary did above. In other words, you need a market for IOUs. That is just what the bond market is, where such loans are traded in the hundreds of billions of dollars every day.

But trading loans needs some standardization and that’s what bonds are: loans re-packaged in standardized ways. Once done, the bond market allows lenders to create money. It’s that easy. It may now dawn on you why your mailbox is always overflowing with offers to lend you money – especially if you have good credit. Many of these lenders are aiming to sell your IOU and create some cash for themselves!

You may wonder, what happens to the IOU/bond once sold? Well, the trading goes on for a bit until the bond ends up with bond investors. These guys don’t sell loans any further, preferring to collect the interest payments. The original lender is now a mere servicer – moving interest payments along to these investors. This means that the financing for your loan ultimately comes from bond investors. The original lender typically loans you the money based on the knowledge that he can quickly sell the loan to investors.

The explosion of credit in the last thirty years or so has been possible due to bond investing. Even the credit card in your wallet is part of the game. Let’s say you buy an expensive item with your American Express card and pay for it over time. You now have a loan from Amex which will very often be sold as a bond. Typically this is done by bundling your debt together with the debt of thousands of others and selling the whole bundle to a bond investor. The bundle of debts is now a security: an Asset Backed Security (ABS) to be exact. The people investing in the ABS will receive your monthly payments, not Amex.

But credit cards are the mere tip of the bond iceberg. Got an auto loan? Its the same thing. ABS securities contain auto loans too. You get the car, investors get your monthly payments. Then you have home loans i.e. mortgages. Mortgages are the big daddy of ABS securities, comprising over 80% of the entire consumer loan market. For this reason we pay our respects and club them separately as Mortgage Backed Securities (MBS).

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The $40 trillion of bonds outstanding in the US dwarfs both the US stock market and the GDP. We have not included here loans which are not traded as bonds such as the $2.8 trillion of IOUs contained in the Social Security Trust Fund and loans funded directly from bank deposits. Source: SIFMA

Corporate bonds are another goliath in the bond market. American corporations together owe over $8 trillion in bonds. This includes firms as diverse as Exxon Mobil, Walmart and your familiar cab service, Uber, which has raised billions of dollars in bonds to fund its so far loss-making operations.

The cycle of loans for everyday needs flows through the whole world in the form of bonds. At one end of the cycle is you, the consumer. At the other end is the bond investor.

These investors are none other than the population as a whole. The ABS, MBS, corporate bonds etc are all placed into bond mutual funds which make up the 401(k)/IRA plans of individuals like you and me. Things don’t stop there though – pension plans, corporations, university endowments, you name it, they all have a massive need for bonds.

We all borrow money loaned to us by all of us. The bond matrix connects all of us to everybody else. You could even end up lending some money to yourself if an MBS in your 401(k) account happens to contain your mortgage (!)

But that’s not typical. The cycle of credit is linked to the cycle of life. As you know, loans produce regular interest payments. If that sounds like income without working, you are right, and that is just what retired folks need. With 40 million people over 65 in the US alone, there is huge demand for passive income of this sort. It makes its way to senior citizens through bonds held in their IRAs and 401(k) plans. Mammoth pension funds add to that – such as the $300 billion California Public Employees Retirement System or the $130 billion Teachers Retirement System of Texas which hold huge inventories of bonds to pay retired employees.

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Somewhere between the age of 55-64 the typical American transforms from a net borrower into a net lender through his holdings in bond funds. As the two bars on the right show, senior citizens lend out about $3 for every $1 that they borrow. Source: Survey of Consumer Finances, 2013.

Traditionally, young people used to mooch off their own senior family members to get started in their lives and eventually returned the favor by supporting them directly. As the figure above shows, nowadays we borrow money collectively from all older people and support them – also collectively – through interest payments.

This is not to say that seniors are the only bond investors. Anyone who needs a steady, predictable supply of income is a customer. Universities for one. Despite exorbitant tuition, universities still face budget shortfalls due to over-spending on football and bloated administrations. To make ends meet they use income from bond holdings in college endowments which range from Harvard’s $40 billion war chest to Rutgers’ $1 billion piggy bank.

Bonds form a colossal cycle of money that roars through the economy day in and day out, flowing through bank accounts and credit cards, funding purchases of every sort. If this cycle halts, even for a bit, the economy experiences the human equivalent of a heart attack. That is just what happened for a few deathly months in 2008 when the world’s economic heart, i.e. the banks, were frozen by the shock of the collapsing real estate bubble. The bond investors disappeared which meant that lending stopped and then so did purchases. And so millions of people lost their jobs because demand fell. We survived 2008, arguably due to Federal intervention, but only just and recriminations continue.

Speaking of governments, note that bonds are more general than stocks. Any two people or entities can create a loan merely by signing a piece of paper and exchanging money. Stocks are much harder to create and there is an expectation of profits. Now what, pray, is less profitable than the US Federal Government? Nothing else on earth: the government spends hundreds of billions of dollars more than it raises through taxes. Being a democracy we get what we want: more spending, less taxes. Our democratic fate. (No pun intended).

But that leaves a huge gap in the federal budget which is filled by borrowing some $700 billion every year. The government does this by issuing treasury bonds also known simpy as “treasuries” or “govies”. These are the 800 pound gorilla of the bond market, comprising about 40% of the whole. Naturally, our retirement plans are heavily invested in treasury bonds too! In God we trust…

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This chart shows holders of the $15 trillion or so of US Treasury bonds. The green(ish) sections show domestic holders – a total of about $9 trillion is owed between all of us and the Federal Reserve. Only $6 trillion is owed to foreign nations and just about one-fifth of that to China. You may want to remember that next time you hear a politician raise the China bogey! Source: US Treasury

It is worth dwelling on the uniqueness of treasuries as opposed to other bonds. You see, the federal government wields constitutional authority which gives it a number of options in case the debt becomes hard to pay. It can raise taxes for instance. It can also issue new debt to pay the old (this is not a joke, they have been doing it for years). And in a pinch, it can even print new money. Such is sovereign power. This is largely true for other nations too, as long as they issue debt in their own currency.

But US dollars are special. Typically no one in the world will refuse payment in the greenback because it is backed by the enormous power and prestige of the United States. Yes, that is indeed an enormous thing, evben in these days where the China bogey is tossed around quite casually. For this reason, US treasury debt is the safest possible investment in the whole world. The US Treasury is unlikely to default in any significant way, except in national emergencies so dire that bonds are likely to be the last thing on your mind!

With that thought we come to a very important point that investors should know. In severe economic crises the safest place for your investments is likely to be treasury bonds. Unless and until the US federal government falls apart, you can safely lend to the treasury and collect whatever meager interest rate they offer. It follows that during economic downturns there is treasury bonds are in demand while stocks sell off. Treasuries therefore typically appreciate during recessions and the worse the economy, the more they are likely to appreciate! Ergo, treasuries can be a great hedge against stock market losses.

The year 2008 was a good example of this. Stocks lost nearly 40% of their value in that year but treasuries came out smelling of roses and cupcakes: many t-bonds rose by almost 20%! That’s pretty cool isn’t it? If you had bought $2 of these bonds for every $1 of stocks, the losses and gains would have canceled out. This is one of the great insights into investing linked to something known as risk parity.

However, it’s not easy to create a risk parity portfolio in the real world. Perhaps by the time we are done with this blog it would be feasible, but for now please don’t try it at home!