Then came last week’s Pfizer announcement of the success, in a trial, of its vaccine. Ten-year bond yields spiked to almost one per cent before slipping back to about 90 basis points at the end of the week.
That late slide in yields came as it dawned on bond (and equity) investors that even if the vaccine were cleared for distribution it would take many months and the creation of a very complex new distribution system before there could be sufficiently wide distribution for the vaccine to have a material impact on the course of the pandemic.
With the pandemic now raging across the US and Europe again there is a lot at stake for investors in the effectiveness of a vaccine and how quickly mass distribution can occur.
The outlook for the US and the global economy hinges on it – even more so in the US now that it is likely (albeit not certain) that the Republicans will retain control of the Senate and are unlikely to allow the Democrats to execute their big-spending plans.
So too does the value of many trillions of dollars of government and corporate bonds.
Where equity investors have remained bullish, after plunging in response to the initial shock of the pandemic in March, bond investors have been pricing in years of very low growth, low inflation and ultra-low interest rates that would be capped by a continuation of the aggressive central bank interventions sparked by the pandemic.
What’s good news for economies and shares spells losses for bond holders.
The Fed, for instance, has made it clear it sees no material movement in US interest rates until 2023. The Reserve Bank has cut the cash rate to 0.10 per cent and its increased asset purchasing program envisages it remaining at ultra-low levels for at least three years.
Thus low rates, and the expectation that they will remain at negligible levels for the foreseeable future, are baked into bond markets.
Just over a week ago the stock of bonds globally with negative yields, as measured by a Bloomberg Barclays index, hit a record $US17.05 trillion ($23.5 trillion).
Those bonds, which have been mainly issued in Europe and Japan (Germany’s 10-year bunds have been trading at a yield of minus 0.55 per cent), reflect a flight to safety, with investors effectively paying issuers a fee to keep their cash safe.
It is also possible to generate capital gains from negatively-yielding bonds if rates continue to fall deeper into negative territory so the willingness of investors to buy bonds that will, at face value, return them less than they invested isn’t only about paying for security.
For existing bond investors, the prospect of a faster than anticipated pick-up in economic growth if the vaccine is successful and widely distributed and accepted is not the good news that it is for equity investors, or for yield-hungry bank depositors.
There is an inverse relationship between bond prices and bond yields. If interest rates rise the value of existing bonds, with lower yields, falls and vice versa. What’s good news for economies and shares spells losses for bond holders.
Conversely, as has been the case for most of this year, falling rates produce capital gains for existing bond investors.
If vaccines results in a strong rebound in economic growth, rates will rise and the Fed and its peers might be able to begin tapering their monetary policy interventions earlier than they envisage or is now factored into markets.
That is, of course, a big “if” and one where the qualifications have massive consequences for markets.
If the pandemic continues to worsen in developed economies and the development or distribution of the vaccines proves to have more issues than the markets are currently factoring into their pricing then the prospect of big capital losses for holders of bonds with negative or ultra-low yields will recede.
If all goes well, particularly in the US – if the pandemic is contained earlier and the Democrats are able to get more of their spending programs through Congress than currently appears likely – rates will rise and the losses to existing bond investors will be substantial.
It isn’t just bond investors that have a lot at stake.
Ultra-low rates lower companies’ costs of borrowing and provide lifelines for companies with otherwise unsustainable balance sheets. Even companies ravaged by the virus – cruise companies and airlines, for instance – have seen both their share prices and the value of their bonds rise since the Pfizer announcement.
There’s been a scramble to increase risk exposure that will end badly unless all the dominoes required to bounce back quickly from the pandemic fall neatly but there’s also the potential that an abrupt rise in interest rates could raise the cost of servicing debt for companies teetering on the brink – the so-called “zombie” companies that are only staying afloat because borrowing costs are so low.
Stephen is one of Australia’s most respected business journalists. He was most recently co-founder and associate editor of the Business Spectator website and an associate editor and senior columnist at The Australian.