“Dump Bonds” = Flee Real Estate

Bloomberg reports that Marc Faber says to “buy stocks and sell cash and bonds because governments are continuing to print too much money and may create a new credit bubble.”

This makes sense: interest rates move inversely to bond prices, so when interest rates increase, bond prices decrease. Since interest rates are at historic lows and are bounded below by zero, they don’t have anywhere to go but up. That means that bond prices will crater.

So, let’s consider residential real estate. (For the rest of this post, when I refer to “real estate,” I am referring to owner-occupied residential real estate.) Real estate is primarily a debt-financed asset. There are certainly people who have enough cash on hand to buy a house or an apartment without taking on a mortgage, but for all intents and purposes, most real estate purchases are partially financed with debt.

Mortgages are a form of collateralized bond, in which the underlying collateral is the house or apartment. Bond prices, as we know, move inversely to yields: as interest rates decline, bond prices increase, and as interest rates increase, bond prices decrease.

Interest rates are bounded below by zero: you can’t have a negative interest rate, else the borrower would receive interest payments from the lender, instead of the lender receiving interest payments from the borrower. Talk about an absurdist dream!

Therefore, if mortgages are merely a kind of bond, and are collateralized by the underlying real estate, it doesn’t make sense to buy real estate when interest rates are low. Recall that bond prices move inversely to yield. The buyer of real estate thinks to himself “Great! I locked in a low interest rate on my mortgage; therefore, I’m saving money on interest payments.” This is true, but it also ignores the very important point that if present interest rates are at historic lows, they have nowhere to go but up. This means that subsequent borrowers are going to buy more expensive capital (because the interest rates will have increased). If capital is more expensive in the future, guess what happens to real estate?

Yes, that’s correct: the price will decline. Accordingly, it makes no sense to argue, as many real estate brokers do, that real estate is a good investment “because interest rates are at historic lows.” Indeed, it makes more sense to argue that one should not buy real estate when interest rates are low.

Now, this analysis depends, of course, on the proportion of debt and equity used to finance the purchase. The more equity you put into the equation the less the current interest rate matters, and the more correct it becomes to argue that low interest rates present a buying opportunity. But since very few people put a large chunk of equity into their down payment these days, it remains true that those who buy because of low interest rates are playing a fools’ game with future interest rates. Few aspiring homeowners have the means or knowledge to hedge against future interest rate increases.

Given the inexplicable link between interest rates and bond prices, one wonders why the government has been encouraging homeowners to buy housing with artificially cheap capital.