Near the Ceiling

Solutions in a world where bonds have nowhere to go but down

Bonds are a favored investment vehicle in Israel and around the world, but they have a certain characteristic that not everybody knows about. Unlike shares, property, commodities or practically any other financial asset, bonds have a ceiling above which they can't rise.

It's a mathematical thing. A bond price can continue rising on the stock exchange as long as demand for it persists, but not to infinity. For each bond there's an equation assuring that ultimately, its price will reach face value and no more. That's the amount the investor receives on the last day of the bond's life, the day the bond matures.

In the past, that ceiling didn't much matter to investors. Anybody who bought corporate bonds a little over a year ago has done well, since the global economic crisis lowered the price of corporate bonds a great deal. In the years preceding the crisis, corporate bonds benefited investors irrespective of capital gains, because of the high levels of interest rates.

Today things are different. Interest rates are low and investors are starved for capital gains. The result is that bonds are near their ceiling.

This process has affected the bond market in two ways. First and foremost, corporate bond prices are high and they've stayed high; they have little or no more room to climb. Serious capital gains, whether on corporate bonds or government bonds, are almost impossible to achieve. Moreover, while bond prices may stay high for the time being, they won't stay there forever.

Second, the yields inherent in bond portfolios held by Israel's savers are just about as low as they can go. Ten-year fixed-income bonds issued by the Israeli government are yielding 4.4%. Linked 10-year bonds are yielding 1.9%. Those are the figures in gross terms. After taxes, the figures are even worse - 3.7% on 10-year fixed-income bonds, and 1.2% on bonds linked to the consumer price index.

The situation abroad is no better. In fact, it's worse. Ten-year U.S. treasury bonds were generating a yield of 2.8% at the end of last week, in dollar terms. In Europe, 10-year government bonds were generating yields of about 2.6% in euro terms. In Japan, savers buying 10-year government bonds are getting returns of 1%. Anybody who wants more must accept risk, for instance in the form of Hungarian bonds (7.2% ), South African bonds (8.4% ) or Greek ones (10.2% ).

The situation in corporate bonds isn't much better. IBM, for instance, recently sold three-year bonds yielding a non-princely 1%.

Israelis had been accustomed to achieving good returns on their pension savings. Losses suffered in 2008 were, by and large, recouped. But from now on, the yields are scraping the bottom, and that's without another global economic crisis.

What to do? There are three possible solutions.

1. The government could decide to sell special investment vehicles to long-term savers. It's done so before, in the form of "designated bonds" that it sold to pension funds. But today's government doesn't view the distress of the long-term saver as a problem for it to solve. The Finance Ministry is behaving like a grocery: Its sole motivation is to reduce its own cost of borrowing. The state has therefore been issuing short-term bonds not linked to the consumer price index.

If the government had in mind the needs of people due to retire in 20 or 30 years, it could issue high-yield 30-year bonds.

One can't blame the Finance Ministry. Its job is to manage the budget and borrow money at low cost. But one can ask the cabinet to take the long view and help savers now, rather than face sure crisis in 20 or 30 years.

2. The second solution lies in the hands of the savers, or rather, the institutional investors that manage their money. They can increase risk. In bonds, risk is inverse to returns. Instead of investing solely in safe government and corporate bonds, they could have a fling with riskier companies or countries.

The riskier sort of bonds offer high yields and could be part of a diversified portfolio. Take the bonds issued by Greece or Africa Israel: for the time being, all is well, and if they reach maturity without giving their holders a haircut, today's buyers will be sitting pretty tomorrow.

Those are two extreme examples. Other deals don't look quite as good and the risk-reward ratio tends to be unattractive. Would you take the not-so-small risk of the issuer's bankruptcy for a few fractions of a percent more?

3. The third solution may sound weird, but it's the most practical of the three: Accept the reality.

Yields are going to stay low for a long time. That's how it is. It may change one day, but until then, keep a stiff upper lip. Grasp the reality with both hands and figure out how to live in a world of low returns.