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 exceptionally well, in stark contrast to the stock market. 30-year ultra-long-term government bonds and their ETFs have also been extremely popular, to the point where even the central bank has expressed the intention to sell government bonds to control risks. So why would government bonds, known for their low risk and stability, experience such a situation?
- This article refers to a WeChat article: https://mp.weixin.qq.com/s/66ZmhV4E_Qn8Ak2MwKYkGg. Here, I will provide a conceptual understanding rather than a detailed calculation method.
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, the yield of government bonds increases and their prices decrease. Conversely, when interest rates are cut, the yield of government bonds decreases and their 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, which may be at a premium or discount. If it is at a premium, you can sell the bond in your possession directly without waiting for maturity, and thus obtain a higher yield than the coupon rate. The opposite is also true.
- In simple terms, if you hold a bond with a yield of 5%, when the market is in 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 it at this time, you can only do so at a lower price. This is why bond prices decrease during interest rate hike cycles. Of course, you can continue to hold the bond until it matures to receive the principal and interest, thus avoiding the impact of interest rate hikes and cuts.
- The bankruptcy of Silicon Valley Bank was caused by their holding of a large amount of 10-year US Treasury bonds, while the US was in an interest rate hike cycle, leading to a decrease in the price of the 10-year Treasury bonds. At this time, depositors began to withdraw funds in a run on the bank, making it impossible for Silicon Valley Bank to wait until the end of 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 period of time it takes to recover the investment in a bond, or how long it takes to get the money back. For example, if the maturity is 10 years and there are no cash flows (such as interest payments) during these 10 years, and you can only receive the principal and interest at the end of the 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 WeChat article.
- 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 receive my original yield, and thus will not be 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 continuous 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 prices will plummet. Betting on continuous 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, risks will emerge. 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 continuous interest rate cuts are likely to occur in the future, which is why they do not offer high interest rates for long-term bonds. This is also 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 by borrowing and selling them (essentially shorting government bonds), which will cause the yield of government bonds 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 the yield of government bonds rises, it will actually attract more investors seeking stability to buy government bonds, resulting in a similar effect to interest rate hikes. This contradicts the previous practice of easing and lowering deposit rates while reducing the coupon rate of government bonds. Therefore, I personally believe that shorting government bonds can only pose short-term risks at most, 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.