ACT 10- The Bond Market Giveth, and the Bond Market Taketh Away (Insurance Part 1)

 

Too few people understand the bond market, or how critical a bond market is to financial systems. It’s the next most important thing to the rule of law.  I’ve emphasized the importance of the bond market in ACT 8 when I reviewed Jim Rickard’s book “The New Great Depression - Winners and Losers Post Covid World”. The bond market is critical, and today’s show examines how it impacts Canadians in massive ways without them even realizing it.

Bond yields have been dropping for 20 years. The government of Canada Benchmark 10 year Bond Yield saw a high of 5.95% on May 29, 2001, and a  low of 0.46% on June 31 2020. The real return of the long term bond has been flirting with zero percent since 2015, and has been LESS than zero for seven months strait starting in July 2020.  Yes you heard me right, owning bonds recently means you would have earned a negative real return on investment.  

 

Low bond yields have been great for borrowers, and the low cost of debt has helped push up the prices of rental property and contributed to compressing CAP rates.  With more money in the system and lower mortgage payments, people can afford to pay more for real estate. This means anyone who wants to own a piece of property can bid up the price of the property higher. 

For example, let's say I want to buy a building with rental income that will support a $6000 per month mortgage payment.  Let’s say the building is in great shape, so I can get the lender to agree to have the loan amortized over 30 years. My combined principal and interest payment of $6000 per month is one million dollar mortgage.  If interest rates drop to from 6% to 1%, that same million dollar mortgage now has a payment closer to $3000 per month.  

 

In fact, that same building that can support a $6000 monthly payment can now support a 1.8M mortgage, so someone in the marketplace may now be willing to pay up to $800,000 more for that same building, just because interest rates have lowered.  This is a simple example of how lowering interest rates can increase the price of assets.

The capitalization rate is compressed when building rise in value. Since buildings are also valued using the income approach, when CAP rates compress, small moves in the income can make big differences in the building valuation. When a building operator like me purchases a building and renovates, the building can command higher rent and also will have Lower expenses. This increases the net income of the building, and with a prevailing market CAP rate of 5%,  every dollar of net income = $240 of building value.

To illustrate this point, a 35 unit building I own increased in value by over $1.6M dollars in only 2 years thanks to a substantial renovation.  This is how the bond market impacts my business, and how I came up with the title to this episode. 

 

The bond market giveth, and the bond market al taketh away.  Let’s discuss the taketh away part now.

There is a concept called counterparty risk in investing.   The liability on one person’s balance sheet is an asset on another’s.  In the above example, the lowered cost of the mortgage makes for a cheaper liability on my balance sheet, and I think that is great. But that mortgage is packaged up by the bank and sold to large investors like pension funds and insurance companies.  The low yielding mortgage is an asset on these investors balance sheets, and a terrible performing asset lately because interest rates are so low.  Large investors are earning less on mortgages and on bonds than inflation, are effectively losing money, and have been doing so for a long time. 

 

The bond market is something few people give a second thought to, but it is responsible for very large changes to many other markets, including insurance. Historically low interest rates and low bond yields are contributing to an insurance crisis in Canada that no one is talking about. The market for insurance has harded to such a degree that it’s really hurting Canadians.  Next episode we will dive into the details of that, and I’ll share some stories about what we’ve been going through lately.