Beyond bond bubbles: Liquidity-adjusted bond valuation

Real t-bill and bond yields have been falling for decades and are incredibly low right now, even negative (see chart below). With an eye to historical real returns of 2%, folks like Martin Feldstein think that bonds are currently mis-priced and warn that a bond bubble is ready to burst.

Investors need to be careful about comparing real interest rates over different time periods. Today's bond is a sleek electronic entry that trades at lightning speed. Your grandfather's bond was a clunky piece of paper transferred by foot. It's very possible that a modern bond doesn't need to provide investors with the same 2% real coupon that it provided in times past because it provides a compensating return in the form of a higher liquidity yield.

[By now, faithful readers of this blog will know that I'm just repeating the same argument I made about equity yields.]

Here's a way to think about a bond's liquidity yield. Bonds are not merely impassive stores-of-value, they also yield a stream of useful services that investors can "consume" over time. In finance, these consumption streams are referred to as an asset's convenience yield. (HT Mike Sproul)

For instance, the convenience yield of a house is made up of the shelter that the house owner can expect to consume. A Porsche's convenience yield amounts to travel services. What about a bond's convenience yield? I'd argue that a large part of a bond's convenience yield is comprised of the liquidity services that investors can expect to consume over the life time of the bond. Let's call this a monetary convenience yield.

In an uncertain world, it pays to hold a portfolio of goods and financial assets that can be reliably mobilized come some unforeseen event. A fire alarm, a cache of canned beans, and a bible all come to mind. Liquid financial instruments, say cash or marketable bonds, are also useful since they can be sold off quickly in order to procure more appropriate items. This ability to easily liquidate bonds and cash is a meaure of their monetary convenience.

Even if the unforeseen event for which someone has stockpiled canned beans or bonds never materializes, their holder nevertheless will enjoy the convenience of knowing that in all scenarios they will be secure. The stream of uncertainty-shielding services provided by both a bond and a can of beans are "consumed" by their holder as they pass through time.

This monetary convenience yield is an important part of pricing bonds. Prior to purchasing a bond, investors will appraise not only the real return the bond provides (the nominal interest rate minus expected inflation) but will also tally up the stream of future consumption claims that they expect the bond to provide, discounting these claims into the present. The more liquid a bond, the greater the stream of consumption claims it will yield, and the higher its monetary convenience yield. The greater the stream of consumption claims, the smaller the real-return the bond need provide to tempt an investor into buying. (HT once again to Mike Sproul on consumption claims)

Which brings us back to the initial hypothesis. If the liquidity of government debt has increased since the early 1980s, then we need to consider the possibility that bonds are providing an ever larger proportion of their return in the form of a monetary convenience yield, or streams of future consumption claims. If so, the observed fall in real rates isn't a bond bubble. Rather, negative real rates on treasuries may reflect technological advances in market microstructure and improvements in bond market governance that together facilitate the increased moneyness of bonds. Put differently, investors aren't buying bonds at negative real interest rates because they're stupid. It's possible that investors are willing to accept negative real interest rates because they are being sufficiently compensated by improving monetary convenience yields on bonds.

I find this story interesting because we usually think that in the long term, real interest rates are determined primarily by nonmonetary factors, including the expected return to capital investments and the time preferences of consumers. The story here is a bit different. In the long term, real interest rates on bonds are determined (in part) by monetary forces. The higher a bond's monetary convenience yield, the lower its real interest rate. Oddly, bonds may be bought not by consumers who are willing to delay gratification, but by impatient consumers who want to immediately begin consuming a bond's convenience yield (ie. using up future consumption claims). The line between consumption and saving is blurred and fuzzy.

In my previous post on equities, I gave some numbers as evidence for the increased liquidity of stocks. Bonds aren't my shtick, so I won't try to prove my hypothesis. All I'll say is that the rise of repo markets would have contributed dramatically to bond market liquidity since repo increases the ability to use immobilized bonds as transactions media. Give Scott Skyrm a read, for instance.

There is a case of missing markets here. If we could properly prices a bond's monetary convenience yield, then we could get a better understanding of the various components driving bond market prices over time.

Imagine a market that allowed bond investors to auction off their bond's monetary convenience yield while keeping the real interest component. Thus a bond investor could buy a bond in the market, sell (or lease) the entire chain of consumption claims related to a bond's liquidity, invest the proceeds, and be left holding an illiquid bond whose sole function is to pay real interest. By stripping out and pricing whatever portion of a bond's value is related to its monetary nature, investors might now precisely appraise the real price of a bond relative to its real interest payments. Excessively high real prices relative to real interest would indicate overvaluation and a bubble, the opposite would indicate undervaluation and a buying opportunity.

But until we have these sorts of markets, we simply can't say if bond prices are in a bubble. Sure, real rates could be unjustly low because bonds prices have been irrationally bid up. But they could also be justly low if bonds are simply providing alternative returns in the form of monetary convenience. Without a moneyness market, or a convenience yield market, we simply lack the requisite information to be sure.

Consumption isn't a fleeting burst of pleasure, it's a long-lived asset

I've learnt enough about the terms income, savings, consumption, investment, capital, and other major macroeconomic categorizations to pass a basic economics exam. But I've never been a big fan of the style of thinking these terms force on me. Am I just being lazy? I'll lay out my points and give an alternative.

Squarely Rooted recently commented on the somewhat arbitrary nature of the boundary economists set between consumption and saving, opining that travel should be thought of as investment, not consumption. On twinkies as savings, here is Squarely Rooted from an earlier post:

Think of a Twinkie. Twinkies are an odd product; on the one hand, they are a cheap, delicious, unhealthy snack; on the other hand, they are (at least according to legend) practically immortal. So is buying a Twinkie consumption or saving? Does it depend when you eat it? And for those who will say “but Twinkies aren’t an investment, they bear no interest, they just sit there” – so does money under the mattress, and nobody thinks that isn’t saving.

As Squarely Rooted notes, dividing the world into categories allows for discussion, but it also "pre-digests" the world for us. This is what Nick Rowe once called the Borges Problem:

We get very different results depending on how we categorise the world. And sometimes the categories we use are chosen by someone long ago who had a totally different purpose and/or a totally different theory to ours. Our way of seeing the world gets distorted by the dead hand of historical ways of seeing.

This cuts both ways. While the dominant technique of linguistically dividing up the world may distort our way of seeing things, having multiple languages can be equally problematic. Here is Steve Randy Waldman:

Our various allegiances — to schools or tribes or policy ideas — exploit the ambiguity of language to manufacture conflicts, through which we reassure ourselves that we are right and they are wrong. (And no, math doesn’t help much, because we must map it arbitrarily to the same ambiguous language for it to be of any use.) Now I will reassure myself that I am right and they are wrong.

It seems to me that looking at the world through a set of different categorical lenses can give us some great insights, as long as those lenses are coherent. But we need to be aware that there are many different taxonomies. Learning how to recognize each and being able to translate between them will probably save us eons in lost time arguing about semantics.

Back to the basic set of categories under discussion. The typical view is that income is a flow, part of which gets apportioned to consumption. Consumption spending is immediately used up, providing a sudden burst of consumptive joy before disappearing for eternity. The unspent income that remains is defined as savings, and this in turn will be invested with an eye to the future, primarily to fund consumption down the road. Most savings will go into capital, though some of it might leak into money hoardings.  Equipped with these categorizations, economists can go out into the real world and determine what falls in one basket and what falls in the other.

The line being drawn between consumption and savings is based on the distinctions between now vs. later and durable vs. nondurable. Let's try a different way of splitting up the world. Suppose that all consumption goods and experiences are long-lived durable assets. They are forms of income-yielding capital in which one invests. Canned beans bought for my pantry will provide a burst of consumptive joy several months from now. Until then, just having them in a pantry provides a stream of useful services, much like a fire alarm provides utility even though it is never used. These are what Steve Horwitz calls availability services. Both the food we keep in our larders and our fire alarm quell uncertainty and soothe us.

If I take out my employees to the bowling alley, I'm investing in organizational capital. But when I go out to bowl by myself, I'm drawing down my wealth on a one-time shot of consumptive joy, at least according to way the lines are currently drawn. Why not consider both to be long term investments?

Take travel spending. As Squarely Rooted points out, travel is a perpetuity. The travel asset that you might be considering purchasing provides an immediate burst of raw travel experience (not all of it fun), followed by a perpetual flow of memories, experiences, and knowledge that continues till death. Any one who swaps out a security, say Microsoft, from their portfolio for a travel asset has determined that on the margin, the present value of the flow of dividends provided by a voyage exceeds the present value of a flow of Microsoft dividends.

I recently splurged on an expensive meal and did so not only to enjoy the near-term burst of flavours, but also for the long-term flow of returns that my investment would produce, namely the opportunity to remember my experience and talk about it with others. Until I forget my experience a few years from now, it'll have provided me with repeating chain of returns. On the other hand, I'll probably sell out of the gold futures contract I just bought in a month or two. Which of these two swaps is the future-oriented durable one and which is about the here & now?

When someone spends their income on so-called consumption they aren't drawing down their stock of savings. Rather, they're swapping asset x in their portfolio for asset z.  The choice to buy food, travel, and get a haircut isn't a depletion or exhaustion of wealth—it's a portfolio adjustment. Consumption is a stock, not a flow. We can calculate the discounted value of all yields thrown off by a consumption good or experience over time and sum these flows up into a stock value.

We are always conducting asset swaps in order to grope towards portfolios with the highest net present value. Our personal capital is probably our greatest asset. When we earn income, all we've really done is swapped personal capital, time & effort, for a bank-issued liability. We commit to this swap because we estimate that the NPV of additional bank-issued liabilities will more than offset the lost NPV of personal capital.

In equilibrium, the returns on all assets are equilibrated through arbitrage. Investing $10 in cigarettes should provide the same prospective flow of services as investing $10 in a trip to somewhere, $10 on a massage, or $10 in Microsoft. If the yield on some consumptive asset, say a massage, exceeds the economy wide rate of return, individuals will sell their Microsoft shares and go off to the masseuse. This process continues until the price of massages has increased to the point that it no longer makes sense to conduct this arbitrage.

What about the classical bias against so-called consumption? Say that rather than swapping out bank-issued liabilities for Microsoft shares we swap them for a long-lived travel asset. Economists would say that we have high time preference and are sacrificing future consumption for present. Society says we've splurged on silly consumption. It seems to me that as long as we've made this decision by appraising each asset's future earnings stream, who cares if we've chosen Microsoft or travel? All we've done is clocked the two NPVs against each other and purchased the one with the best yield relative to its cost.

Microsoft shares have one advantage over a travel asset. They are liquid. Travel experience can't be resold. In committing your entire portfolio to travel, the problem isn't that you've sacrificed future consumption for present consumption, nor that you've sent money down a black hole. Rather, you've rendered your portfolio less liquid. People who reallocate their portfolios towards travel are asset rich, but liquidity-poor.

While we can't directly remonetize our travel asset, we can indirectly remonetize it. If travel and good food improve our spirits and productivity, then we can recombine these benefits with our labour and resell the total product at a higher price than before. So investing in consumption assets can be a great idea. But in general, it's probably not a good idea to invest everything one owns in illiquid consumption assets. Liquid assets will always be good in a bind.

Getting back to the Borges problem, how does reconceptualizing things this way lead to different results? The old lines between capital, land, and labour aren't so important, nor is the axis between the household and firm. Nor does the distinction between durable and non-durable goods concern us. All we have are millions of yield-generating assets that are constantly moving in or out of individual's portfolios. The main difference between these assets is their swappability, or their liquidity. It's a good platform on which to start thinking about moneyness.

Even if you don't agree with me on any of this, I hope you see how the Borges problem operates. How we choose to linguistically parcel up the world influences the way we take in and sort data, and the data we generate is the base for our actions, policies, and institutions. We've built up an incredibly large edifice based on our initial categorizations. Hopefully we've gotten them right.

Debt, generations, savings, and economic categorization or the "Borges Problem"

I didn't comment much on the great debt debate, stirred up a Krugman post called Debt Is (Mostly) Money We Owe to Ourselves, but followed it quite closely.

Nick Rowe taught me (here, here, here, and here), and Bob Murphy clarified (here, here, here, here, here, here, here, and here), that present generations can indeed take resources from future generations via debt issuance.

I also learnt via Daniel Kuehn here and here that if you use a very unintuitive definition of "generations", than this is not the case. Basically, you can swap the meanings of terms to argue your way out of a tight spot.

My comment is from a Murphy post:

I’ve learnt that the method by which one aggregates individuals into groups, and the labels that one attaches to such groups, can have an important influence on a debate’s ability to reach resolution. If people are aggregating differently, and using non-standard words for their categories, then the debate will degenerate into shouting matches.

In a comment on a post called Why "saving" should be abolished, Nick describes this as the Borges Problem, which I rather like. Says Nick,

Let me first do one general response:

 There are lots of different ways we can divide up the world into categories see Borges on "animals" http://en.wikipedia.org/wiki/Celestial_Emporium_of_Benevolent_Knowledge%27s_Taxonomy

 Which would be the most useful way to divide up income, and define saving?

 Which of these 3 definitions of desired saving is the most useful?

Nick later on:

Notice also that the recent debate about the burden of the debt was also an example of the "Borges Problem". Do we divide the future up into time periods or into cohorts? We get very different results depending on how we categorise the world. And sometimes the categories we use are chosen by someone long ago who had a totally different purpose and/or a totally different theory to ours. Our way of seeing the world gets distorted by the dead hand of historical ways of seeing.

Yes! I did notice that. It caused me a lot of confusion. Nick also notes that the solution is to choose the most useful categorization out of all possible options, and proceeds to advocate a different category to which we should attach the word "savings". Interesting stuff. I'm not sure how Nick proposes we solve for "usefulness" though. Isn't the fact that almost everyone uses the same term for a given categorization a good enough claim for usefulness?

Here's another Rowe comment on Kuehn's blog which is relevant:

Put it another way: there's more than one way to aggregate. We shouldn't let our theories of what is happening in the world be determined by the choices made by long-dead National Income Accountants.

Anyways, in my comment on Nick's savings post, I proposed a more useful (at least to me) Borgian response to the categorization problem. Instead of categorizing the world on the basis of flows, categorize it as a series of balance sheets, or stocks. The result is that consumption, investment, and savings are all attached to entirely different bins (and more intuitive ones, to me at least) than in a world composed in terms of flows:

Nick, I agree with you that the conversation on debt was mainly about categorizations and the lack of standardized terms associated with categorizations. That made it very frustrating to follow.

So I am all in favor of standardizing terms, as you advocate in this post. 

I noticed you originally introduced C and I as flows and A and M as stocks. Then when you brought in the individual's economy, you introduced not a stock of antique furniture, but a flow of antiques, and not a stock of money, but a flow of money. Presumably you did this to preserve stock flow consistency.

The idea of a flow of antiques or money is very unintuitive to me. Why not go the other way? Not flows of consumption and investment, but stocks? Thus you have and individual's goods C, I, A, and M, which are all stocks. Sum them all up and you have S (the noun form of S, not the verb). This S can rise or fall. As a solution to the Borgian categorization problem, this configuration makes more intuitive sense to me.

And later:

N: "but if we think of income as a flow, then thinking of C and I as stocks is going to create problems."

 Me: You start out with the C and I that you have produced in your stock of assets, hold this C and I until you find someone who'll exchange for them with the M they have in their stock of assets. Now they are holding C and I and you are holding M. So here income isn't a flow, it's just a trade, an instantaneous swap of assets held in a portfolio.

 How much of economics is taken up by definitional debates and confusion? You'd think there would be a universal set of definitions for economic terms somewhere so these issues don't pop up. When I read William Hutt's books I'm always pleased because he uses his first chapter to explicitly define every term he'll be using.

and once more *phew*:

N: "Will those trades all take place in an instant, with some buying and some selling a stock of antiques? Or will those trades happen slowly over time, as people buy or sell a flow of antiques, and slowly get back to their long run desired stocks? That depends. If antiques are a small part of your wealth, and the market is frictionless with all antiques identical and so zero search costs (obviously not, for antiques). Each person would instantly buy or sell a stock of antiques to get back to his personal desired stock. Otherwise, there will be a flow of trades. If antiques are a large fraction of your wealth, you may only buy and sell slowly, in a flow."

 me: Ok, thinking in a world with stocks, (an infinite series of balance sheets), trades still happen in an instant, even if you introduce search costs. You hold the antique on your balance sheet until you don't. The antique is in your hand up until the moment it enters the hand of the buyer.

 Introducing frictions means that someone can have the intention of selling that antique and will need to incur costs to search out someone to trade. But it doesn't mean the process must be a conceptualized as a flow. Rather, the intention of selling an antique just moves the antique to a different part of an individual's balance sheet. It continues to lie in the asset column of their balance sheet, but is moved from long-term assets to current or liquid assets. Introducing search costs means that instead of an interval of two balance sheets before a swap occurring, the interval is some number larger than two.

My rough final thoughts are that thinking in terms of stocks, not flows, introduces a number of important categories that flow-based economics ignores because it is focused on flows. The most important of these is a stock of non-durable consumption goods. In flow-based economics, it's always been odd to me that factories produce, and we instantaneously use up, consumption goods.

A stock based world also is terribly confusing way to go about things, because the word savings in a flow-based world is attached to a different category than that which it is attached to in a stock based world, much like how in the Great Debt debate the word "our children" can be attached to either a period of time or a cohort.