Why do long-term government bond prices skyrocket during interest rate cuts?#
- Recently, the bond market in our country, especially long-term bonds, has performed very well, in stark contrast to the stock market. 30-year ultra-long-term government bonds and their ETFs are also extremely popular. Even the central bank has expressed its intention to sell government bonds to control risks. So why is it that government bonds, known for their low risk and stability, are experiencing such a situation?
- This article refers to the article on the public account: https://mp.weixin.qq.com/s/66ZmhV4E_Qn8Ak2MwKYkGg. Here, detailed calculation methods are provided. I will only provide a conceptual understanding here.
The impact of interest rate hikes and cuts on government bond prices#
- The yield/interest rate of government bonds is usually inversely related to their prices. When interest rates rise, bond yields increase and bond prices decrease. Conversely, when interest rates are cut, bond yields decrease and bond prices increase.
- Please note that the yield of government bonds is not the promised interest rate at the time of issuance. That is the coupon rate, which is fixed. The yield is influenced by the price of the bond because the bond may be trading at a premium or discount. If it is trading at a premium, I can sell the bond I hold without waiting for maturity and obtain a higher yield than the coupon rate. The opposite is also true.
- Simply put, if you hold a bond with a yield of 5%, then during an interest rate hike cycle, newly issued bonds will have a yield higher than 5%. At this time, you will find that the bond you hold is not as good as the newly issued one. If you want to sell at this time, you can only sell at a lower price. This is why bond prices fall during an interest rate hike cycle. Of course, you can continue to hold the bond until maturity to receive the principal and interest without being affected by interest rate hikes or cuts.
- The bankruptcy of Silicon Valley Bank was caused by their holding a large amount of 10-year US Treasury bonds while the US was in an interest rate hike cycle, which led to a decrease in the price of the 10-year Treasury bonds. At this time, depositors began to withdraw their money, leading to the inability of Silicon Valley Bank to wait for the 10-year period to recover the principal and interest of the bonds. They could only sell the bonds at a lower price to return the money to the depositors, ultimately resulting in bankruptcy.
Understanding the concept of bond duration#
- Duration represents the time it takes to recover the investment in a bond, that is, how long it takes to get back the money invested. For example, if the maturity is 10 years and there is no cash flow (such as interest payments) during these 10 years, and the principal and interest can only be obtained after 10 years, then the duration is 10 years. If interest is paid annually during the process, the duration will be less than 10. The specific calculation can be found in the article on the public account.
- Duration directly affects the sensitivity of bond prices to changes in interest rates, and can be simply understood as the risk level or leverage of the bond. For example, if the duration is 10, a 1% fluctuation in interest rates will cause a 10% fluctuation in price.
- To give an extreme example, if a bond is redeemed in just one day and my yield is 5%, even if I reduce the interest to 0%, as long as I hold it for one day, I can still get the original yield without being affected by interest rate fluctuations.
Investment logic for medium and long-term bonds#
- Due to the long duration of our ultra-long-term government bonds (about 20 years), if I bet on continued interest rate cuts in the future, the price of these long-term bonds will skyrocket! However, if the expectation is no longer interest rate cuts, it is very likely that the price will plummet. Betting on continued interest rate cuts is actually a bearish view on the future economy, as interest rate cuts are usually implemented to stimulate the economy in the face of deflation. Therefore, the risk here is that once the economy recovers or other profitable investment opportunities arise, or if the central bank switches from interest rate cuts to hikes, there will be risks. Of course, because the current yield of long-term bonds is not higher than that of short-term bonds, this indicates that our banks judge that interest rate cuts are likely to continue in the future, which is why many institutions are currently betting on the bond market.
- Then we can also understand the recent actions of the central bank. The central bank hopes to lower the price of government bonds through borrowing and selling (essentially shorting government bonds), which will cause bond yields to rise and reduce the risk of events similar to the Silicon Valley Bank incident in the future. However, the problem here is that when bond yields rise, more investors seeking stability will buy government bonds, resulting in an effect similar to interest rate hikes. This contradicts the previous practice of easing and lowering deposit interest rates and bond coupon rates. Therefore, I personally believe that shorting is at most a short-term risk, and the long-term risk lies in whether the economy can recover and whether investment opportunities other than QDII, bonds, and high dividend stocks can be found. Once funds flow elsewhere and the supply of bonds increases, causing prices to fall, or if inflation occurs leading to interest rate hikes, it will have a devastating impact on medium and long-term bond investments.