In the first installment of my interview with Vineer Bhansali, the author of The Incredible Upside-Down Fixed-Income Market from the CFA Institute Research Foundation, we addressed the underlying implications of negative-yielding bonds, whether they constituted a net negative or positive.
Bhansali, who is also CIO of LongTail Alpha, emphasized that negative-yielding bonds are neither “good” nor “bad,” but rather a new territory that investors must adapt to.
In the second part of our discussion, Bhansali draws parallels between negative-yielding bonds and options, discusses future US Federal Reserve policy, and explores Treasury Inflation-Protected Securities (TIPS), among other related issues.
CFA Institute: You write that a negative-yielding bond closely resembles an option. Tell me more about this and where you see opportunities in this “upside-down” fixed-income market, to quote the title of the monograph.
Vineer Bhansali: Negative-yielding bonds share several characteristics with options. Firstly, investors pay a premium for protection, similar to the premium paid for an option. Secondly, the value of the premium decays over time, just like the time value or decay of an option. And finally, negative-yielding bonds exhibit convexity, meaning they can have explosive performance under specific scenarios.
For example, consider a zero-coupon bond with a negative yield. This bond requires investors to pay a premium upfront, which eventually decays to zero if nothing significant happens. However, if an extreme event occurs, such as a market crash, the value of the premium can increase significantly due to further negative yields.
These characteristics make negative-yielding bonds similar to options, both in terms of their pricing and potential for positive returns.
In 2020, the word that dominated discourse was “unprecedented.” In 2021, it is “negative rates” and “inflation.” The Fed is one of the few central banks holding out on cutting rates into negative territory. In the monograph, you pose several questions — and I’m just going read some of these out because I would love to find out the answers: Will it go negative? When and how will that happen? Or will inflation become the next major problem?
Bhansali believes that the US Federal Reserve may still cut rates into negative territory if certain conditions are met. One potential scenario is a crash in the market coupled with a catastrophic meltdown, which could lead to a negative wealth effect and deflation. Alternatively, if inflation becomes a major problem due to the significant increase in asset prices caused by low interest rates, the Fed may also consider going negative.
Bhansali also discusses the rise of inflation and its connection to low interest rates. The increase in asset price inflation could eventually trickle down into consumer goods, causing a rise in inflation.
Speaking of the Fed, Jerome Powell’s term as chair ends in February, but many people expect him to stay in the job. Do you think he will?
Bhansali believes that Jerome Powell may likely stay in his position as chair of the Federal Reserve. As a lawyer by training, Powell has the necessary skills to manage the expectations and behavior of market participants during this era of high debt. Bhansali also emphasizes that the government’s involvement in the financial markets is now a permanent fixture, and Powell’s role as chair is crucial in managing this new dynamic.
You’ve written a number of articles on Forbes — you’ve mentioned a couple — and one that I saw fairly recently was on TIPS, or Treasury Inflation-Protected Securities. TIPS have been in the news recently. So, for those readers who don’t keep a close eye on TIPS, can you just give a snapshot of what’s happening in the market now?
Treasury Inflation-Protected Securities (TIPS) are indexed to inflation and are issued by the federal government. Bhansali highlights the importance of the TIPS market, particularly the real yield, which indicates inflation expectations. The Fed plays a significant role in managing the TIPS market, as they are one of the largest buyers of TIPS and strive to keep inflation expectations anchored. This control by the Fed has changed the dynamics of the TIPS market, as market participants now rely on the Fed’s actions to determine prices.
Vineer, your career in the markets has spanned three decades. You survived the global financial crisis (GFC) of 2008 and 2009. You have weathered the brunt of the global pandemic. What long-term scars — if any — do you think COVID-19 will leave on investors of your generation? Are they different from the GFC?
Bhansali does not see COVID-19 leaving scars on investors, but rather a sense of humility. The pandemic has reminded everyone of the limitations of modern advancements and the vulnerability of the system. He also highlights that COVID-19 has solidified the government’s permanent role in the financial markets, which will have long-term implications for investors.
So my closing question for you: One of my roles at CFA Institute is to host the Take 15 Podcast, and so I can’t resist asking something I ask every guest — and this is very apropos for you as you trained as a theoretical physicist.
I got the idea after listening to an old episode of This American Life in which John Hodgman conducts an informal survey asking the age-old question: Which is better? The power of flight or the power of invisibility?
So, you have to choose a superpower, flight or invisibility. Which one do you choose? And what will you do with it?
Bhansali, who is also a pilot, chooses flight as his preferred superpower due to his love for flying. He finds joy and fulfillment in exploring the world from above. He admits that being invisible could be intriguing, but the opportunities that come with flight are unmatched.
This article was originally published by CFA Institute on their website.
