Bonds Can Get “Crushed” During a Deflationary Depression

Originally published by Forbes on January 25, 2018 Read the original article.

Despite what conventional wisdom says, bonds are no safe haven during a deflationary depression.

In the Great Depression of the early 1930s, bonds suffered a big bear market just like stocks.

This is from Robert Prechter’s Conquer the Crash:

Any bond issued by a borrower who cannot pay goes to zero in a depression. In the Great Depression, bonds of many companies, municipalities and foreign governments were crushed. They became wallpaper as their issuers went bankrupt and defaulted. Bonds of suspect issuers also went way down, at least for a time. Understand that in a crash, no one knows its depth, and almost everyone becomes afraid. That makes investors sell bonds of any issuers that they fear could default. Even when people trust the bonds they own, they are sometimes forced to sell them to raise cash to live on. For this reason, even the safest bonds can go down, at least temporarily, as AAA bonds did in 1931 and 1932.

Today, EWI’s analysts expect another deflationary trend to develop. In such an environment, they do not expect bonds will offer financial safety.

Now, let’s turn to the views of a Forbes contributor in a Jan. 25 article titled “Default, Devaluation Or Debt Deflation — Time To Exit Longer Maturity Treasuries?”:

The United States has trillions of dollars of debt held by creditor countries and the dollar discussion brings to the fore how this debt will be settled when it comes due.

A debtor has four ways of settling what he owes a creditor.  First, the debtor can “grow” out of the debt.  The hope is that economic stimulus from exports that follow a short-term weaker dollar will be sufficient to generate revenues to pay the coupons and principal over time.  Whether the U.S. can grow quickly enough in the medium-term to become a net creditor seems very unlikely given that new deficits will result from the recent tax cuts.

A second way of settling what is owed a creditor is by defaulting on the debt.  Given the right of the sovereign to print more dollars, we can safely assume that the United States will not take this route and will pay off the face value of the debt as it comes due.

Devaluation of the dollar is the third option. If the dollar is devalued, then the real value of the debt declines.

Finally, and related to the devaluation “option,” is deflation of the debt by creating inflation.  Rising inflation reduces the terminal value of the obligations, i.e. it “deflates” the real value of the payables.  Deflating the debt by creating inflation thus “kills softly”, but for all practical purposes is also a default on obligations that is spread out over many years. Devaluation thus reduces the value of the obligations not by outright refusal to pay, but rather by payment in a future currency that is worth much less than its value today.

This brings us to the question of what all this means for financial markets. …

You can read the entire article by following the link below:

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