A bond is a debt instrument, usually issued by a government, municipality or company to raise funds for operations or projects. When you buy a bond, you are actually lending money to the issuer and receiving regular interest payments, also known as coupons, and the principal returned at maturity.
Compared to stocks, which represent company ownership and are more volatile, bonds generally have more predictable return characteristics. Because of this, they can provide a certain buffer effect for portfolios during market fluctuations, thereby reducing overall risk. This makes bonds an indispensable part of a sound investment strategy and suitable for investors who seek stable returns or diversified asset allocation. Therefore, bonds play a very important role in managing risks and providing stable returns.
The recent crisis news about the sustainability of national debt in the market has made investors worry about the sustainability of bond market returns and low risk. In addition, the future interest rate decisions of the Federal Reserve will also have a huge impact on bond yields. Investors' duration management of bonds, control of interest rate sensitivity and credit risk awareness are very important for bond investment.
Debt Impact
Market Crisis News: "Government Fiscal Deficit".
When deficit panic theorists sound the alarm again and again, they believe that the huge debt scale will further deteriorate the fiscal situation and eventually trigger a credit crisis in the United States. Different from the mainstream view, I believe that the trend of the deficit continues to rise is becoming more and more obvious, but the root of the problem is that the debt funds have not flowed to the productive field, but are more used to maintain short-term consumption and fill the fiscal gap. The debt problem in the United States will not first break out in the Treasury market. It has long been and will continue to be reflected in the real economy... This is actually the same as Japan.
I believe that the real risk of debt does not originate from the market's reaction to Treasury bonds, but more from the gradual erosion of the quality of economic operation.
In essence, government debt is a non-productive expenditure, so it is often regarded as having a "negative multiplier effect" in economics. This means that in the long run, every additional dollar of government debt may weaken the overall economic size. Although this may sound counterintuitive - after all, government spending does stimulate economic activity in the short term, but this boost is often difficult to sustain.
The funds needed to repay the debt usually come from private capital, which could have been used for more productive investment projects. The result is that over time, the burden of past deficits is eroding today's growth potential. If deficits really help economic expansion, why has the US fiscal deficit continued to expand over the past four decades, while GDP growth has shown a gradual decline?
As we mentioned earlier, Japan is a real case: its long-term economic stagnation is closely related to the large-scale fiscal spending taken by the government after the financial bubble burst. It is these non-productive expenditures from deficits that are quietly weakening our economic foundation.
Therefore, investors should correctly consider the erosion of deficits on the quality of long-term economic growth and the efficiency of capital allocation. It will gradually weaken the vitality of the real economy, increase inflation risks, and compress the investment space of the private sector, but it will not directly trigger a crisis in the Treasury market in the short term.
The asset attributes of government bonds are changing
It is a clear fact that the United States currently carries a total federal debt of more than $34 trillion. Whenever we see a chart showing the scale of debt that the US government needs to refinance in the next few months or quarters, there seems to be a "peak of impending maturity". But considering that about 25% to 35% of the current US debt is short-term Treasury bills, that is, instruments that mature within one year, the refinancing pressure naturally presents a cyclical concentration, and the continued rise in government bonds is actually the natural result of the establishment of the structure of government bonds.
It is not an exaggeration to say that the continued fiscal deficit will eventually translate into the accumulation of government debt.
In fact, this situation is not fundamentally different from the past decade, and a similar structure is likely to be maintained in the next few years. More importantly, most investors holding Treasury bonds are long-term institutions or central banks themselves, and bonds are usually automatically extended when they mature, so the US Treasury does not need to repeatedly find new buyers for these debts.
Because the Federal Reserve has maintained a tight policy for a long time in the past, especially during the epidemic, the negative impact on the long-term US bond market was much smaller than it is now. In the context of persistent inflation expectations, tightening policies actually help stabilize market expectations for long-term interest rates. It not only reduces actual risks, but also alleviates the psychological pressure brought by inflation. In terms of the current macroeconomic environment, a prudent tightening attitude may have more advantages than disadvantages, but the Fed does not seem to intend to do so.
Another point worth noting is that investors are worried that due to the reduction of US credit risk, the global bond sell-off will cause bond yields to break through the risk neckline and even bring serious inversion risks. However, it is worth noting that the large-scale selling of US Treasuries by foreign governments is not the main factor posing a threat to US Treasuries. In fact, the main purpose of these countries holding or selling US Treasuries through central banks is to manage their own exchange rates, not investment returns or concerns about US finances.
When the US dollar strengthens, these countries will sell US Treasuries to support their currencies; when the US dollar weakens, they tend to increase their holdings of US Treasuries to prevent their currencies from appreciating too quickly. Therefore, even in the face of geopolitical frictions or trade disputes, this logic of foreign exchange reserve management will not change easily.
As we mentioned earlier, the risks faced by long-term treasury bond holders are more about eroding the vitality of the real economy, especially in the context of the current expanding fiscal deficit. This type of risk is mainly reflected in two aspects:
First, there is supply-side pressure. As the fiscal deficit rises, the government will inevitably need to continue to issue more treasury bonds, which will aggravate the imbalance between supply and demand in the long-term bond market, push up interest rates and lower prices; second, there is a mismatch of macro resources. Deficit expansion often means that a large amount of savings will flow from the more efficient private sector to the public sector, resulting in a decline in capital utilization efficiency and may push up medium- and long-term inflation expectations.
The most worrying situation is that the fiscal deficit is not only large in scale, but also shows a long-term upward trend in its share of GDP. This will weaken the government's fiscal flexibility and suppress the value of long-term treasury bonds.
As a result, for investors, this means two important changes: first, the allocation logic of treasury bonds has shifted from yield hedging tools to risky assets, especially bonds with longer durations, whose price sensitivity to interest rates and inflation expectations is gradually increasing; second, the defensive ability of the traditional "debt-equity balance" model is weakening. If bonds cannot effectively hedge against the stock market downturn, the overall volatility of the portfolio will increase significantly, which will force institutional and individual investors to re-evaluate their asset allocation strategies.
What bonds can investors choose?
The macro changes that have taken place in the past three months have made investors realize the importance of bonds. In the stage where inflation continues to ease and economic growth momentum weakens, the role of bonds is first to provide stable returns, and secondly to serve as a defensive tool for asset allocation when the economic cycle switches. As the market's expectations for the Fed to start a rate cut cycle heat up, even if the actual pace of monetary policy shifts is still uncertain, the direction has become clearer. For the bond market, this means that a potential re-rating window is opening.
We have to start with the interest rate cycle. Since bond prices and interest rates are negatively correlated, entering a rate cut cycle means that medium- and long-term bonds will benefit significantly from the duration effect. In the rate cut cycle, medium- and long-term bonds have longer durations, more room for price increases, and more impressive investment returns. As the US yield curve is still in an inverted state, market concerns about the economic outlook have not been resolved. Investors can adopt a combination of short-term debt defense and long-term debt game allocation: let short-term debt provide a steady cash flow and lock in the current relatively high interest rate level, while long-term debt bets on capital gains from future interest rate cuts.
Not only that, compared with the current high-valued US stocks, the risks and returns of bonds are becoming more attractive. US Treasury bonds, investment-grade corporate bonds and municipal bonds are all supported by the shift in interest rate expectations. Investment-grade corporate bonds have the dual characteristics of stable returns and lower risks, which is a good choice for investors seeking defensiveness; for investors with higher risk appetite, although high-yield bonds ("junk bonds") have high credit risks, they may still outperform some stock market sectors due to higher interest payments in the context of a mild economic slowdown and controllable default rates.
In addition, investors can pay attention to bond ETF tools with flexible allocation capabilities. TLT long-term US bonds, IEF medium-term Treasury bonds, LQD investment-grade corporate bonds and HYG high-yield bonds can all be used as core or auxiliary assets in the investment portfolio to help investors capture bond market trends or hedge against stock market fluctuations.
It is also worth noting that the Federal Reserve's balance sheet policy. If the Fed stops shrinking its balance sheet or restarts quantitative easing (QE) in the future, it will further boost bond demand, thereby supporting prices. When market liquidity tightens or risk appetite declines, bonds still have the ability to be a safe haven for funds under the premise of rising yields.
From the perspective of credit spreads, the current spread between high-yield bonds and government bonds is still low, reflecting that market risk sentiment has not been fully restored. If the future economic weakness exceeds expectations, the widening of the spread will further compress the space for risky assets, and the defensive attributes of bonds will be magnified.
