Four words certain to strike fear into the heart of many investors: negative yielding debt bonds.
These are bonds that on maturity, yield less than they cost to buy. And while they may decrease in value individually, they’re on the increase in number and that in turn is increasing the global economy’s exposure to these sub-zero investments.
In fact the total value of the negative yielding debt bonds market now stands at many trillions of dollars, and there are several reasons why it’s unlikely to turn around any time soon.
As a consequence, the old rules of investing in bonds are being broken, creating new challenges for funds that are directly linked to this asset class.
Where does negative value come from?
The negative yield on a debt bond normally arises from investors buying in at a higher price than the bond is due to pay out over the remainder of its life.
Simple mathematics means that if they hold on to the bond until maturity, the investor makes a loss.
Other factors can also have an influence, for example exchange rates if the bond is in a different currency than the investor’s own, and we’ll look at why this is significant in a moment.
How did this happen?
In the current economic cycle – which can be traced all the way back to the sub-prime lending crisis and the credit crunch starting in late 2007 – many central banks were unable to reignite economic growth in the years that followed.
Some opted to instate sub-zero interest rates, including several in Europe in 2014 and soon after them, Japan.
This effectively charges financial institutions for holding capital rather than lending it out, and was a temporary measure designed to improve the availability of credit immediately following the credit crunch.
However, the European Central Bank benchmark deposit rate has remained at -0.4% since 2016 – charging institutions €4 in every €1,000 to deposit capital – and many economists are predicting it will fall further, pushing more bonds into negative yield territory.
Why do people buy sub-zero debt bonds?
The relatively high confidence in the value of bonds makes them a tempting proposition during turbulent markets, such as those we have seen due to geopolitical upheavals in recent years.
But this high level of demand pushes the balance away from supply – and as usual, that means prices go up, making it harder to buy bonds with a positive yield.
At the same time, some funds are committed to tracking government bond indices, which forces them to buy at any price – even at an expected loss.
Finally, the currency exchange rate effects mentioned above also play a part, as they can mean bonds that are loss-making in their own currency are still profitable for overseas investors.
That’s particularly bad news for domestic investors, who don’t have the privilege of exchange rate effects to help make bonds in their own economy a brighter prospect.
How much are people buying?
If negative yielding bonds sound like a niche market, think again. Bloomberg reported earlier this year that over a quarter of global investment-grade debt is now accounted for by negative yielding debt.
Between December 2018 and July 2019, the amount of money put into sub-zero debt investment more than doubled to reach over $14 trillion.
According to Bloomberg, that includes all German government bonds, which have an overall yield of -0.5%.
Interestingly at the same time, the US government’s $16 trillion debt was still entirely in positive territory, but globally the trend is very much towards those negative numbers.
Who profits from this?
If individual investors are losing, then who is winning? In the case of government debt bonds, it’s the governments – they are essentially being paid to borrow money.
At the same time, the option to issue bonds makes borrowing much cheaper for businesses too.
Private equity firms that rely on leverage to acquire companies can also use the cheaper availability of capital to increase their exposure to new opportunities.
And just to prove that it’s not all bad news for the man or woman in the street, this all filters down to cheaper borrowing for households too, particularly in the form of standard variable rate mortgages.
Who is losing out?
The losses from sub-zero bond yields reach into several areas of investment. One area with particular exposure is the pension funds market, which traditionally looks to government bonds as a reliable source of income.
With ageing clients and a risk-averse strategy, these funds now face zero to negative yields from an asset class that has historically been a key element in their portfolios.
Bank margins are also being squeezed, which is why many consumer banking current accounts and even savings accounts currently pay interest rates between zero and just a few decimal points at most.
Ultimately the low cost of borrowing could make it unprofitable for banks to issue new loans, leading to a decrease in availability, which in turn may impact on economies and spur the start of a slowdown.
Should we worry?
For investors, it’s a mixed picture. Obviously the prospect of achieving a positive yield from government debt bonds is lower in a climate where more are returning zero to negative pay-outs on maturity.
There are longer-term implications too though. It’s a guiding principle of investment that lending money for longer should reap a greater profit, but negative yields fly in the face of that.
Long-term bonds are depreciating substantially in value in the space of a couple of years, which makes them less appealing to investors and could decrease activity in the market, leading to stagnation.
And as a consequence, those investors may be forced to look elsewhere, gambling on greater risk and volatility in search of a return, with the possibility that this could create boom-and-bust bubbles in specific asset classes.
Why aren’t things turning around?
Recovery from the recession looks fairly good from ground level, but the bigger picture is less bright.
Employment is up but wage growth is slow; households are under less pressure financially but inflation is still very low.
Geopolitical uncertainties continue to impact on many economies and industries, and several of the key indicators point towards the potential of renewed contraction in the medium term.
If this were to happen, many of the central banks – especially in Europe – would have little option but to head deeper into the negative numbers, as they have failed to raise their base rates since their previous downward trajectory.
What does it all mean?
If a new recessionary phase were to emerge, the central banks would likely look to their usual weapons of choice – interest rate cuts and quantitative easing – to try and inject value and activity into their economies.
This could create a whole new period of very low growth and inflation, with minimal yields available on many traditional asset classes as a result.
At the same time, safe haven investors would be likely to continue to look at bonds as a reliable option, intensifying the imbalance between supply and demand and pushing yields further into the red.
Who knows where this might end? A reversal of fortunes in global economies could inspire a climb-out from the trench, but it will need to do so before bonds plough to a depth beyond arm’s reach.
If they hit the banks’ reversal rate where it becomes uneconomical to lend, this ironically could lead to yet another credit crunch, this time created by insufficient market value instead of excessive market risk.
And all the while, the risk of a boom-and-bust bubble in other asset classes increases as investors are forced to look out of their comfort zone to higher risk, higher volatility investments to replace the value they are not receiving from bonds.
https://www.bloomberg.com/news/articles/2019-07-13/the-black-hole-engulfing-the-world-s-bond-markets-quicktake
Disclaimer: The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
