In Margin of Safety, Seth Klarman’s cult classic on investing, the hedge fund manager recounts a tale of an unusual mania for sardines that briefly struck California when the fish disappeared from the coast of Monterey.
The shortage sent prices rocketing, and eventually local traders bought and sold sardine tins purely on the confidence that they could quickly flip them to another buyer at a higher price. But one day, a trader decided to treat himself to a sardine meal, and became violently ill. When questioned, the seller had a simple explanation: “You don’t understand. These are not eating sardines, they are trading sardines.”
For sardines, you can now read bonds. Even after the recent correction, a third of the developed world’s government bond market is still trading at prices that exceed their total coupons and principal, in practice guaranteeing investors a loss if they cannot sell the securities to another buyer for a higher price than they paid.
All bubbles have some rational underpinning. The current bond market is propped up by $180bn of monthly central bank buying that shows no sign of slowing, as well as negative short-term interest rates in Europe and Japan, a swelling savings glut, and mounting concerns over the health of the global economy.
And there are other reasons why one would buy bonds that yield less than zero, aside from avoiding negative rates or a plan to flip them to the local central bank. Bonds are the bedrock of the financial system for both commercial and regulatory reasons.
Many transactions require some safe collateral, and financial institutions are compelled to hold a big chunk of their money in bonds. Factors including the price of currency swaps can also make buying a negative-yielding overseas bond economical.
But the sense that we have lost track of the fundamental point of bonds — providing fixed income, not fixed losses — is inescapable. The US Federal Reserve is unlikely to metaphorically force traders to “eat the sardines” — using Mr Klarman’s phrase — by raising interest rates later this week. But at some point, we will all wake up and smell the rotting fish.
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