Fixed income debt instruments, including bonds, are the backbone of the financial system. It becomes a big problem if, and when, they are worthless. Billionaire hedge fund manager Paul Singer thinks as much.
“Today, six and a half years after the collapse of Lehman, there is a Bigger Short cooking. That Bigger Short is long-term claims on paper money, i.e., bonds,” he wrote in his recent letter to investors in his Elliott Management funds, outlining his idea to sell-short bonds in order to buy them back later and make a profit in the process.
As of this moment, there are just under $60 trillion of credit instruments outstanding in the United States alone—and Singer thinks they will drop in value.
Here is why: All of these fixed income instruments are called like that because the income is, well, fixed. You receive a predetermined rate of interest every year, and at the end of the term, you also get back the money you invested in the first place, as long as the borrower is in the condition to repay you.
This would be the nominal return on your investment. However, as an investor, you should be concerned with the real return on your investment, as Paul Brodsky pointed out earlier.
This means adjusting the nominal return for any reduction in purchasing power, that is, inflation or increases in prices. If prices increase above your nominal return over the time period of the investment, you can buy fewer goods and services, the exact opposite of the point of investing.
Singer now believes that all those bond investors are trapped in the paradox of central banking: “The goal of leaders of developed nations and their central bankers should be more or less the same: enhanced growth and financial stability. But somehow the principal policy goal of both has become to generate more inflation.”
Right now, consumer price inflation in the United States is actually negative, falling 0.2 percent over the last 12 months to April. The goal of the Fed is to have positive inflation of 2 percent per year.
In order to achieve that goal central banks buy bonds, driving up prices, and driving down yields. Despite the low yield, if bonds rise in price, investors are making money, albeit not that much, and are happy to stay in the trade. The paradox is that through the process, central banks precisely intend to generate the kind of inflation, which will eat into real profits.
“No investor’s actuarial requirements or investment return goals can possibly be met by today’s long-term bond interest rates, but investors are holding them nonetheless because they have been making money on their bond holdings persistently and seemingly inexorably for the last few years,” he wrote.
By the time they realize inflation is actually losing them money in real terms, it might be too late.
“The day when their perceptions are challenged and they change their minds, only to find that the exit door has been blocked by everyone else doing an about-face at the same time, is going to be one heck of a day for those who have positions in bonds, whether long or short.”