Is investing in bonds a good idea? What trends are implied behind Ray Dalio's "The Stupidity of Bonds" theory?

For the past few decades, U.S. treasuries have been considered the safest assets, with a typical allocation of 40% of assets in treasuries to hedge against the risks of "currency depreciation" or "inflation." However, the bond market has been anything but calm recently, especially as the selling of the ten-year treasury bonds has led to a rapid increase in yields. While most investors believe this is a temporary phenomenon, Ray Dalio, the founder of the world's largest hedge fund, Bridgewater Associates, pointed out in his article " Why In The World Would You Own Dollar Debt?" on the 16th that this may not be a short-term phenomenon.

Only Fools Buy Bonds

Bonds may have transitioned from safe assets to foolish assets.

Ray Dalio believes that the real interest rates (nominal interest rate - inflation rate) of current "reserve currency" bonds (USD, EUR, JPY) have turned negative. These ultra-low interest rate assets can no longer meet the needs of investors, including pension funds, insurance companies, sovereign wealth funds, and savings accounts.

Not only bonds, even the real yield of cash has turned negative. In this scenario, borrowing cash to short bonds seems to become a reasonable choice. Bridgewater Associates' data can explain why the yield of the US ten-year bonds sharply increased (bond prices fell) not long ago, even leading to the phenomenon of "negative yields" in the repurchase market.

The "repurchase market" refers to the situation where the financing party sells securities and signs a repurchase agreement, buying back the assets with interest within a specified period. However, in early March, the seller/lender of the ten-year US bonds could receive interest from the counterparty during repurchase, indicating that the repurchase market has transformed into a place where institutional investors borrow and short the ten-year US bonds.

How foolish is it to invest in bonds now? Ray Dalio explains it in a very straightforward way.

If I buy a $100 reserve currency bond today, when will I break even and start earning interest? US bonds will take 42 years, Euro bonds 450 years, Japanese bonds 150 years, Chinese government bonds 25 years.

Taking inflation into account, it will take another 500 years for the US to actually start making a profit, and it is impossible for Europe and Japan. The image below shows the time required for US bonds' nominal interest rate (left) and real interest rate (right) to start making a profit.

Shifting Tides in the Global Economy

The current situation is that everyone holds a large amount of bonds, while governments around the world are frantically producing bonds, debt, and debt assets, with the US government leading the pack. The article points out that US bonds account for one-third of the bond positions of central banks, sovereign wealth funds, and investors worldwide.

This is because the US has been and is still the world's strongest country, with the US dollar being the world's reserve currency, making USD-denominated assets naturally the safest. This privilege has allowed the US to continue borrowing excessively. It's worth noting that excessive borrowing and debt can threaten the reserve currency. Meanwhile, emerging markets are on the rise.

When one sovereign entity begins to weaken, another rises. Ray Dalio specifically points out that the holding rate of Chinese bonds is increasing. Although international investors currently hold about 6% of Chinese bonds, as the size of the Chinese economy is reevaluated, the weighted proportion of Chinese debt holdings will increase.

On the other hand, if reserve currency bonds continue to increase in supply more than demand, bond prices will fall, yields will rise, and governments will have to increase the scale of quantitative easing to buy these bonds, which will weaken the USD, EUR, and JPY. In contrast, Chinese bonds offer relatively attractive rates, which also drive demand for the Chinese yuan.

A Bubble from the 40-Year Bull Market

For the past 40 years, thanks to economic development and international trade, the bond market has been in a bull market. Therefore, despite the recent bond market decline, it hasn't truly hurt most investors.

But imagine if there was a reason that made everyone holding bonds want to sell. What would happen?

Currently, the total debt assets of various maturity dates of US bonds exceed $75 trillion, with US treasuries and notes accounting for about $16 trillion, of which different tenors of US bonds account for $5 trillion. If yields continue to fall, investors have two options: hold the bonds until maturity and then receive meager interest, or sell the bonds to exchange for other goods and services.

Unfortunately, these amounts are too large to be sold off completely. In other words, once the final line is triggered, everyone will start selling, triggering a negative reinforcement process, and Ray Dalio believes that once triggered, things will become irreversible.

Is Reducing Quantitative Easing Actually Bullish?

Historical data shows that central banks are facing a supply-demand imbalance, where bond yields may exceed what is needed for economic recovery. In this case, central banks need to buy more government bonds to achieve "yield curve control," but this can lead to another problem: the devaluation of cash.

Ray Dalio uses an interesting analogy. He compares the economy to a human, where the government is the doctor. When the patient's pulse drops, the doctor starts emergency treatment, which works, allowing vital signs to start recovering. These vital signs are assets such as stocks, bond indices, gold, and other assets.

This injection of money and credit expansion into the system will push up financial asset prices. When interest rates are lower than the inflation growth rate, repaying debt becomes easier, that is, "borrowing to invest" is wise, pushing up various asset prices even when the real economy is weak, creating an economic bubble. Therefore, when the real economy begins to recover and inflation expectations begin to rise, the dosage of the medicine should be reduced.

Ray Dalio believes that investors can observe the next moves of central banks to see if they will increase the scale of quantitative easing; if so, this indicates they are facing a supply-demand imbalance. In other words, if central banks reduce the scale of quantitative easing, that is the real bullish sign: the real economy is recovering.

The Long-Term Debt Cycle is Coming to an End

The problem with decades of economic stimulus measures is that these stimuli continuously increase debt, leaving unhealthy effects. In a large debt cycle, problems arise when debt growth outpaces income growth. Borrowers hope to get better purchasing power than the bond yield, but lenders bear an additional burden because their interest cannot keep up with the principal.

During a credit/debt collapse, everyone will start to realize the loss of purchasing power, leading to deteriorating financial and economic conditions, and due to excessive debt, tax increases will be necessary. In Ray Dalio's view, we are currently in a credit/debt cycle (not yet hitting the bottom).

In this cycle, the COVID-19 pandemic has worsened the situation. To save liquidity, governments have had to inject a large amount of credit into the market. Despite this, it's evident that financial assets are on the rise.

Nevertheless, asset bubbles are forming. What's worse, in this pandemic, the US government's debt has increased significantly, with the US government deficit reaching WWII levels.

What Should Be Done?

Ray Dalio believes we are now in the late stage of a large debt cycle, so borrowing cash should not be seen as an asset but used for non-debt investments with higher returns.

To channel these funds into the real economy, governments may start raising taxes or imposing restrictions to prevent assets from flowing abroad or moving to other assets such as gold or Bitcoin.

Finally, Ray Dalio suggests that investment portfolios may need to change.

The proportion of non-debt assets and non-USD assets should increase, and diversified allocations will perform better than the traditional 60% US stocks, 40% bonds. He also believes that assets of developed currency reserve countries will not keep up with the performance of emerging markets in Asia (including China).