Why are corporate bond (and Pref Shares) yields falling?

[Gan020]

Bond prices are rising. Pref Shares prices are rising fast. Especially on banks and financial services. Which reduces the yield. I have read elsewhere this is because interest rates are going to stay low for much longer than previously thought.

However, if I look at the best buy tables for banks/building societies, the interest rates continue to rise, being higher for 1,2 and 5 year fixed bonds than they were in January. So, this appears to say interest rates are going up not down.

What I am missing? There seems to be a wall of money going into corporate bonds and pref shares at the moment (and other semi-fixed interest such as REITs etc.)

I can formulate an argument that most of the banks/building societies paying higher rates need to do this as that's the going rate and there are the beginnings of signs of stress in the alternate finance market but I'm struggling with the concept that they are paying higher rates whilst it seems for example Paragon who are one of the mid-sized banks would be paying lower rates and thus suffering less stress. I don't think that makes sense though. I don't think their loan books are sufficiently differentiated.

Any thoughts? At the moment it looks to me like investors chasing yield but not thinking too deeply about the possible capital losses?

[johnhemming]

It strikes me that people are less frightened about the UK economy being hit by a no deal situation.

[GoSeigen]

Bond prices are rising. Pref Shares prices are rising fast. Especially on banks and financial services. Which reduces the yield. I have read elsewhere this is because interest rates are going to stay low for much longer than previously thought.

However, if I look at the best buy tables for banks/building societies, the interest rates continue to rise, being higher for 1,2 and 5 year fixed bonds than they were in January. So, this appears to say interest rates are going up not down.

What I am missing? There seems to be a wall of money going into corporate bonds and pref shares at the moment (and other semi-fixed interest such as REITs etc.)

I can formulate an argument that most of the banks/building societies paying higher rates need to do this as that's the going rate and there are the beginnings of signs of stress in the alternate finance market but I'm struggling with the concept that they are paying higher rates whilst it seems for example Paragon who are one of the mid-sized banks would be paying lower rates and thus suffering less stress. I don't think that makes sense though. I don't think their loan books are sufficiently differentiated.

Any thoughts? At the moment it looks to me like investors chasing yield but not thinking too deeply about the possible capital losses?

Thoughts:
1. Preference share prices are rising: who said that they have anything to do with interest rates? IMO that is a misunderstanding. Preference share prices are highly insensitive/uncorrelated to interest rates aren't they?

2. The wall of money is a myth. There is no wall of money going anywhere.

3. Roughly speaking, interest rates rise because market participants are more reluctant to lend, or more keen to borrow. As such, rising rates may be due to optimism of borrowers in future economic strength, and/or concern by lenders about the ability of borrowers to repay. Clearly these interests are in conflict so it can be difficult to identify who is right. However, thinking about the economic cycle it would be rational for borrowers to be confident in the middle to late part of the cycle, but also for lenders, who know what is coming after the end of the cycle. This is what drives bear flattening and leads to yield inversion (which appeared recently).

4. I don't know about the detail of Paragon and its peers. In the end it's just one company so not too much can be concluded about the macro from the single data point.

5. I don't see much yield chasing myself, in the UK at least. Preference share yields are around 6%, bank equity looks very cheap to me, gilts have been strong so risk spreads are wide. I've loaded up the truck personally. Could turn out very very wrong though... e.g. I was not so bullish in 2016 when UK share prices were some 20% lower...

GS

[PrefInvestor]

Hi goseigen, Well the traditional wisdom is that preference shares behave like bonds ie when interest rates rise prices fall and vice-versa. Pretty well all of the published materials that I have read over the years regarding prefs and bonds is supportive of this position.

The situation on preference share price movements this year is interesting and FWIW I see it as follows. Firstly prices were severely damaged by the cancellation threat made by Aviva last March and thereafter declined steadily until December time, I believe due to the expectation of steady increases in US interest rates (and therefore probably the BoE and others too).

But towards the end of December that all changed when Powell capitulated to Trumps demands to stop raising interest rates and market sentiment also changed from immediately expecting a recession resulting in the major upward move that we’ve seen in the US stock markets. However I believe that in capitulating Powell probably also likely caused the inversion of the yield curve with the (undesired) effect that markets are now expecting a recession sometime in 2020 (though quite why with the US economy and job market both booming I don’t understand).

But anyway coming back to preference shares, the market is now NOT expecting rates to go up and that in fact the next move might actually be down. I suspect that this is in large part responsible for the recovery in pref prices since the end of 2018. But if we are to see a recession then that’s clearly going to be bad news for equities if potentially good for fixed income investments.

This is just my opinion and I could be completely wrong. You are of course at liberty to disagree with my view. As usual only time will tell……

ATB

Pref

PS I bought back into prefs in late November 2018 and all of those investments have done really well, all up in excess of 10% including dividends. Looking forward to more of the same….

[GoSeigen]

Hi goseigen, Well the traditional wisdom is that preference shares behave like bonds ie when interest rates rise prices fall and vice-versa. Pretty well all of the published materials that I have read over the years regarding prefs and bonds is supportive of this position.

Ah, I see where the problem is. You believe/recall that you have heard that bond prices move inversely to interest rates. But that is not entirely correct. What is actually said is that bond prices move inversely to their yield. Which is not the same thing.

-Interest rates apply to money and equivalents of money. Money has a fixed price and an interest rate.
-Yields apply to bonds. Bonds being negotiable have a variable price and from that price we calculate their yield.

The terms yield and interest rate are not interchangeable, and a bond's price moves inversely to its own yield, and not to monetary interest rates. Hopefully that is fairly clear.


Now preference shares, being perpetual, have yields which behave similarly to long-dated bonds. And their prices move inversely to that yield, and not to interest rates. In general you cannot tell what will happen to the bond price when interest rates change.


As a bond investor it is useful to be aware of this distinction.

The situation on preference share price movements this year is interesting and FWIW I see it as follows. Firstly prices were severely damaged by the cancellation threat made by Aviva last March and thereafter declined steadily until December time, I believe due to the expectation of steady increases in US interest rates (and therefore probably the BoE and others too).

No, see the above. In general perpetual security prices have no direct relationship to interest rates, not sterling rates and not dollar rates. They do have a direct mathematical relationship to their own yield.

The Aviva situation did bring prices back to reality. In hindsight though, you could say that Aviva merely exposed the unjustified over-valuation that existed previously. This view is supported by the fact that other perpetual prices also fell into the end of last year: I mean share prices. Preference shares move more-or-less in sync with equity prices. That is why both are rising of late.

But towards the end of December that all changed when Powell capitulated to Trumps demands to stop raising interest rates and market sentiment also changed from immediately expecting a recession resulting in the major upward move that we’ve seen in the US stock markets. However I believe that in capitulating Powell probably also likely caused the inversion of the yield curve with the (undesired) effect that markets are now expecting a recession sometime in 2020 (though quite why with the US economy and job market both booming I don’t understand).

If you keep trying to understand what is happening to long-dated securities in terms of monetary interest rates instead of yields the picture is always going to be murky and confusing. You really need to recognise and accept that there is a yield curve.

There are in fact four named modes of movement of long-dated prices with respect to interest rates. They are the bull flattener, the bull steepener, the bear steepener and the bear flattener. In addition the yield curve is sometimes observed to be moving in sync from short to long.

But anyway coming back to preference shares, the market is now NOT expecting rates to go up and that in fact the next move might actually be down. I suspect that this is in large part responsible for the recovery in pref prices since the end of 2018. But if we are to see a recession then that’s clearly going to be bad news for equities if potentially good for fixed income investments.

Again, fixed income securities are not monolithic. A recession might be good news for high-quality short-dated fixed-interest securities. But it could simultaneously be as bad for lower quality perps and preference shares as it is for ordinary shares, despite their classification as "fixed income" investments.

This is just my opinion and I could be completely wrong. You are of course at liberty to disagree with my view. As usual only time will tell……

Well opinion is one thing, but the relationship between bonds and their yield is mathematical fact. The changing relationship between bond prices (especially long ones) and interest rates at any time is conjecture.

PS I bought back into prefs in late November 2018 and all of those investments have done really well, all up in excess of 10% including dividends. Looking forward to more of the same….

I've also bee buying FI stocks over recent months and hope they do well. But it won't necessarily be related to interest rates falling.


GS

[Alaric]

Well opinion is one thing, but the relationship between bonds and their yield is mathematical fact. The changing relationship between bond prices (especially long ones) and interest rates at any time is conjecture.

Keynes developed economic theory on the basis that there were two types of non-equity investment. These were bank deposits and undated government securities. I've long wondered whether his theories are refutable on the basis that's there's a lot of stuff in between those extremes. When Gideon paid off War Loan and Consols, that removed undated from the Gilt market. Up to a point Preference Shares are all that's left in the undated category of "fixed" income investments.

[GoSeigen]

Well opinion is one thing, but the relationship between bonds and their yield is mathematical fact. The changing relationship between bond prices (especially long ones) and interest rates at any time is conjecture.

Keynes developed economic theory on the basis that there were two types of non-equity investment. These were bank deposits and undated government securities. I've long wondered whether his theories are refutable on the basis that's there's a lot of stuff in between those extremes. When Gideon paid off War Loan and Consols, that removed undated from the Gilt market. Up to a point Preference Shares are all that's left in the undated category of "fixed" income investments.

Without a relevant quote it's hard to comment on Keynes. The second part though, about the lack of perpetual securities is not true to the best of my knowledge. For instance, a quick google search shows Santander issued £750m of perps in 2015 and HSBC £1bn last year. I very much doubt they are the only ones, but do feel free to share your own sources.

http://www.ifre.com/sterling-bond-santa ... ullarticle
https://www.scmp.com/business/companies ... eu-capital

GS

[GoSeigen]

Bond prices are rising. Pref Shares prices are rising fast. Especially on banks and financial services. Which reduces the yield. I have read elsewhere this is because interest rates are going to stay low for much longer than previously thought.
[...]
Any thoughts? At the moment it looks to me like investors chasing yield but not thinking too deeply about the possible capital losses?

Why are long bond and perp yields falling?

1. First, long bonds are self-evidently in a secular bull market. So the primary and simply answer is that nothing much has changed in the underlying trends and the bulls are back doing what they have done for decades.
2. I guess what lies behind the question is: what happened last year and has that finished? Well clearly up to the beginning of 2018 long bonds had had a tremendous bull run and were arguably over-valued with fairly thin spreads over long gilts. Prefs in particular fell sharply and for a time probably pushed down other bond prices in the same investor space (think BOI and Co-op group bonds among others). ISTM last year was a healthy correction in the bull trend which has for now ended.
3. How long yields will fall is anyone's guess. At some point the bull market should stall and possibly even reverse so as always some sensible diversification in portfolios is needed.

GS

[WorkShy]

The market has rerated a number of factors in the last six months: global growth lower (China, Euro area and US from run-off from Trump stimulus), lower long-term inflation expectations (domestic demand seems weak), and the probability of recession higher. In 4Q18 this initially caused equities to fall and bond yields to fall (prices to rally).

In response to that both the Fed and ECB have gone dovish in 1Q19. The Fed implied that they are on hold (with the market seeing a bias for the next move to be a cut). The ECB has pushed out it's guidance for the first rate hike and has even hinted that they may need to cut more. This has allowed equities to rally back (since less chance of policy error causing recession) but also caused government bonds to rally more. The front-end of the yield curve less risk of hikes and more risk of cuts. At long-end, lower inflation expectations and lower growth expectations, so lower real yields.

We are back in what can be termed "secular stagnation" or "Japanification". Investors want yield but also are still somewhat risk averse. So money has been piling into corporate bonds globally. Investors want duration. The yield curve bull flattens. It's often acute in the UK because we have a big scarcity of duration. We regulate our lifers and pensions companies to do liability driven investment so they need long-dated government and investment grade bonds. The government isn't issuing enough Gilts ("austerity" is reducing gilt issuance) so the institutions will grab any duration they can get.

[Alaric]

The second part though, about the lack of perpetual securities is not true to the best of my knowledge.

There aren't any undated British Government securities even if Banks are continuing to raise capital on undated terms.

[GoSeigen]

The second part though, about the lack of perpetual securities is not true to the best of my knowledge.

There aren't any undated British Government securities even if Banks are continuing to raise capital on undated terms.

Please re-read the exchange. [To wit: the thread is about prefs and corporate bonds; Alaric says "Up to a point Preference Shares are all that's left in the undated category"; I counter that there has been significant undated issuance by banks -- so preference shares cannot be "all that's left"; Alaric makes an off-topic and apparently irrelevant comment about British Government securities.]


GS

[hiriskpaul]

In April 2006, NWBD was trading at about 160, when BoE base was at 4.5% and heading upwards (the peak was 5.75% in July 2007). NWBD is currently trading around 147, with base rates at 0.75%.

Evidence enough of a big disconnect between short dated rates and long duration, higher credit risk prefs. There seems to be a perpetual belief by many commenters that the yield curve marches in lock step with short term rates, despite all the evidence to the contrary.

[rippleog]

Preference shares are highly insensitive to interest rates (Base rate) and yields (Gilts)....that is evident

However their value can still be measured against both and particular Gilt yields. NWBD (depending on your assumptions) has a modified duration of approx 13.15 years so we can compare it a against current 1.5% (15yr) Gilt yields...

So prefs are approx 460 basis points over Gilts (current yield at 6.04% with assumed YTM at 5.69%)currently compared to approx 200 basis points pre financial crisis...

So they look very cheap when you consider the risk profile for UK Bank preference share has dramatically improved post 2011.
I suspect they will remain very cheap due to the "prospectus" risk that smacked investors firstly with LLoyds COCOs and secondly with the AVIVA debacle.

(I remain a holder in my SIPP as an annuity alternative)

[GoSeigen]

Preference shares are highly insensitive to interest rates (Base rate) and yields (Gilts)....that is evident

However their value can still be measured against both and particular Gilt yields. NWBD (depending on your assumptions) has a modified duration of approx 13.15 years so we can compare it a against current 1.5% (15yr) Gilt yields...

So prefs are approx 460 basis points over Gilts (current yield at 6.04% with assumed YTM at 5.69%)currently compared to approx 200 basis points pre financial crisis...

So they look very cheap when you consider the risk profile for UK Bank preference share has dramatically improved post 2011.
I suspect they will remain very cheap due to the "prospectus" risk that smacked investors firstly with LLoyds COCOs and secondly with the AVIVA debacle.

(I remain a holder in my SIPP as an annuity alternative)

I agree, this is a much sounder way of looking at the valuation of preference shares, both from the perspective of matching duration, and in the implicit acceptance that pref prices don't track even the longer-dated gilts precisely.

GS

[Gan020]

Thank you for all your posts since I started this thread. Whilst I would consider my understanding of the financial markets to be well above average I realise I far more to learn than I thought I had!

In my own mind I am now comfortable that bond and pref shares are rising due to the macroeconomic climate. Bond prices feel reasonable enough given a bounce back from the yield curve from late December and the situation around interest rates staying lower for longer. Pref shares feel to me like the rise is too fast, too quick. Perhaps the move is now less a case of fundamentals but people jumping on the trade flow to flip for say a 5 percent turn, or perhaps some were sitting on cash thinking prices would go lower and are now happy to pay a higher price. There seems to be a good argument that if say Aviva shares are going up as investors are happy to accept a lower yield, then Aviva prefs should rise in some parallel kind of way. You wouldn’t think so though today as they are going off in reverse directions. Only one day in the history of the stock market I know but there aren’t always rational explanations.

I do still remain puzzled as to why the building societies are paying higher rates in the best buy tables than they were three months ago and no-one has commented on this. If interest rates are going to remain lower for longer, then I would venture the challenger banks would now be able to borrow from the wholesale markets at a lower rate and therefore the rates offered to 3-5 year savers in the personal market should be falling too. But they aren’t, they are going in the opposite direction. Perhaps this is telling me something about credit risk, capital ratios and pressure on the alternate finance market. Maybe the bubble has already burst there given London and Capital Finance going bust and the increasing default percentages on peer to peer. The rates Basset and Gold are now offering to savers suggest to me there may be far more stress in the alternate finance market than is immediately apparent.

Interesting times.

[GoSeigen]

Thank you for all your posts since I started this thread. Whilst I would consider my understanding of the financial markets to be well above average I realise I far more to learn than I thought I had!

In my own mind I am now comfortable that bond and pref shares are rising due to the macroeconomic climate. Bond prices feel reasonable enough given a bounce back from the yield curve from late December and the situation around interest rates staying lower for longer. Pref shares feel to me like the rise is too fast, too quick. Perhaps the move is now less a case of fundamentals but people jumping on the trade flow to flip for say a 5 percent turn, or perhaps some were sitting on cash thinking prices would go lower and are now happy to pay a higher price. There seems to be a good argument that if say Aviva shares are going up as investors are happy to accept a lower yield, then Aviva prefs should rise in some parallel kind of way. You wouldn’t think so though today as they are going off in reverse directions. Only one day in the history of the stock market I know but there aren’t always rational explanations.

I do still remain puzzled as to why the building societies are paying higher rates in the best buy tables than they were three months ago and no-one has commented on this. If interest rates are going to remain lower for longer, then I would venture the challenger banks would now be able to borrow from the wholesale markets at a lower rate and therefore the rates offered to 3-5 year savers in the personal market should be falling too. But they aren’t, they are going in the opposite direction. Perhaps this is telling me something about credit risk, capital ratios and pressure on the alternate finance market. Maybe the bubble has already burst there given London and Capital Finance going bust and the increasing default percentages on peer to peer. The rates Basset and Gold are now offering to savers suggest to me there may be far more stress in the alternate finance market than is immediately apparent.

Interesting times.

Gan020,

Your speculations all seem plausible to me. The exact causes and reasons for the various moves are beyond my pay grade I'm afraid. I agree investors might be chasing preference shares; with the longer duration issues they might be right -- in fact I am trying to adjust my trading approach so that I can buy shares as they are starting to move up rather than long before they have bottomed, which is all too often a habit of mine. So really I should be buying a few pref shares too.

One thing I will say is that if prefs move up in a sustained trend you'd expect equity to follow at some point. So maybe treat their firmness as an indicator to buy the ords on the dips?

Re: Building Societies, is it because they are feeling comfortably profitable now and looking to take market share from the banks/each other? Or is that wishful thinking from someone who invests in BS securities???


GS

[Surerera]

For anyone worried about short rates rising anytime soon, it's worth looking at the 3 month short sterling strip. 5 year futures are little more that 1/2% higher than front month futures.

https://www.theice.com/products/3765033 ... 594&span=3

CONTRACT LAST TIME(GMT) % CHANGE VOLUME
JUN19 99.150 4/23/2019
1:19 PM -0.005 47025
SEP19 99.090 4/23/2019
1:19 PM -0.020 58593
DEC19 99.035 4/23/2019
1:18 PM -0.020 35544
MAR20 99.015 4/23/2019
1:19 PM -0.015 30743
JUN20 98.975 4/23/2019
1:18 PM -0.015 38532
SEP20 98.925 4/23/2019
1:19 PM -0.015 21770
DEC20 98.880 4/23/2019
1:15 PM -0.020 15932
MAR21 98.855 4/23/2019
1:13 PM -0.015 14897
JUN21 98.820 4/23/2019
1:13 PM -0.010 15199
SEP21 98.785 4/23/2019
1:18 PM -0.015 9934
DEC21 98.750 4/23/2019
1:19 PM -0.010 11180
MAR22 98.725 4/23/2019
1:13 PM -0.010 9722
JUN22 98.695 4/23/2019
1:19 PM -0.010 12759
SEP22 98.670 4/23/2019
1:13 PM -0.010 11607
DEC22 98.635 4/23/2019
12:59 PM -0.015 12110
MAR23 98.620 4/23/2019
1:13 PM -0.010 10955
JUN23 98.585 4/23/2019
12:34 PM -0.020 4139
SEP23 98.560 4/23/2019
12:07 PM -0.025 166
DEC23 98.540 4/23/2019
10:52 AM -0.020 153
MAR24 98.520 4/23/2019
12:12 PM -0.025 230