Article by Kristjan Mee Strategist, Research and Analytics at Schroders – 4 September 2019
The collapse in global bond yields since late last year has reverberated through financial markets. Trade tensions, coupled with falling growth and inflation expectations have led to the US 10-year bond yield falling from 3.2% to 1.5%. For bond investors, this drop in yields has generated the best year-to-date return since 1995 (prices move inversely to yields).
But investors’ attention now turns to more dire future prospects. German and Swiss yield curves[i] are wholly negative with even the 30-year bonds yields at -0.1% and -0.5% respectively (Figure 1). This means that an investor putting €100 into 30-year German bonds will get back only €97 in 30 years time. Outside the core of the euro area, the yield curves of Spain and Portugal are negative up to the 8-year maturity.
There are now more than $16 trillion of negative yielding bonds, representing 29% of all global investment grade fixed income assets, as of 22 August 2019. Recently, Nestle issued the first ever negative yielding 10-year corporate bond. The dollar bloc remains the last oasis in the fixed income desert, offering positive, albeit small, yields.
The figure shows the percentage of negative yielding bonds in the Bloomberg Barclays Global Aggregate Bond Index.
Despite going against conventional financial theory, negative yields could be with us for some time. Since 2009 when Sweden first trialled negative policy rates, multiple countries have broken the “zero lower bound”, either to attempt to stimulate their economy or fight back against their currency strengthening (which harms exports by making them more expensive). Even in the US, the possibility of negative yields is now more openly debated. The former Federal Reserve (Fed) Chairman Alan Greenspan recently said that “there is no barrier” to negative yields in the US.
From an investor’s point of view, this raises some serious questions. After all, who wants to pay for lending money? However, buying bonds with negative yields might not be as crazy it sounds. Below we have highlighted six reasons why.
Hedged yields matter
For global fixed income investors, the opportunity set includes various different regions. Normally, investments in foreign currency securities are hedged[ii] to remove the risk of currency fluctuations. The additional cost (or return) from currency hedging can change the attractiveness of bonds, often quite dramatically.
For example, the 10-year German Bund yield at -0.6% appears unattractive for US dollar investors. However, currency hedging rates are based on the difference between US and German short term interest rates and, since US short term interest rates are much higher than in Germany, US investors are effectively paid money to hedge euro exposure. On a currency hedged basis, US investors can earn a yield of 2.2% when investing in German 10 year bonds (Figure 2). This is higher than the 1.6% available on US 10 year Treasuries.
Even though the Fed is expected to cut interest rates, as long as the differential between the US and the euro area remains elevated, German bunds will remain attractive to US investors. The same goes for other key investors of developed market bonds. Currency hedging can transform negative yields into positive yields.
Income vs capital gain
Leaving aside currency hedging, investors in negative yielding bonds are guaranteed to lose money if they hold them to maturity. However, many investors do not intend to do this. An investor who has a view that yields are likely to fall further could buy negative yielding bonds in the expectation that they will benefit from capital gains, if their view turns out correct. They could then sell them and crystallise that gain.
For example, the Swiss 10-year bond was yielding -0.1% at the beginning of the year. Despite this, as of 22 August, it had returned 5.6% so far this year. Negative yields are not an impediment to positive returns. Of course, this works both ways. Any rise in yields could lead to significant losses.
Portfolio diversification benefit
In a broader asset allocation context, bonds still play a vital role, even at negative yields. Figure 3 shows the 3-year rolling correlation between German Bunds and the German DAX stock market index. Besides the period between 2014 and 2017 when the European Central Banks’s (ECB) quantitative easing (QE) programme led to both higher bond prices (lower bond yields) and higher stock prices, there has been a relatively strong negative correlation between the two (Figure 3). In other words, bonds have tended to perform well when equities have been struggling and vice-versa. The risk-reduction aspect is especially important in the times of distress. In “flight-to-safety” episodes, government bonds are usually the primary beneficiaries of capital leaving stocks.
This means that even if negative-yielding bonds detract from return under normal conditions, they can still considerably reduce the risk of a portfolio.
Liability matching with negative yields
Liability-relative investors, such as insurance companies and pension funds, are not always concerned about the absolute level of yields or return prospects from bonds. They often buy bonds as a “match” for their liabilities. The present value of these liabilities is calculated in a variety of ways but often is strongly influenced by government bond yields. For example, in the euro area, the rates used by the insurance industry are negative up to the 11 year maturity point[iii]. Therefore, these liability-driven market participants can buy negative-yielding German Bunds to match a liability in the future. Their values will move in tandem with each other. The alternative of not buying negative matching assets would leave them exposed to significant risks if interest rates were to fall further.
Bonds as deflation hedge
Most asset classes struggle in a period of deflation (when prices fall). Fixed interest government bonds are an exception. Due to their fixed coupon and principle payments, they retain their value and will deliver a positive real (inflation-adjusted) return if inflation falls below their yield. In other words, a negative yielding bond can deliver a positive real return if there is deflation. Negative-yielding bonds can therefore act as a hedge against deflation. Although deflation is not a reality in Europe at the moment, inflation has remained stubbornly low in recent years, despite the best efforts of central banks. As a result many investors are concerned that we could suffer deflation in future – Japan has been grappling with it for more than two decades. Fixed interest bonds, whether positive or negative yielding, would be one of the few asset classes that would be expected to perform well if this comes to pass.
What is the alternative?
Finally, even if investors are not happy about paying to lend money, what is the alternative to owning bonds? Banks have historically not passed on negative deposit rates to retail investors, partly because of concerns it could result in a run on the bank. However, there are signs that this is changing – UBS recently announced that it will start charging negative interest rates on euro deposits over €1 million. Retail deposits may no longer offer a shelter.
Furthermore, deposit insurance schemes only protect bank deposits up to a value of €100,000, so are not suitable for large institutional investors.
Physical cash would be another option. However, there is a cost associated with storing and handling cash. For larger investors they would need to hire a vault, with associated costs and security needs. For many investors this is too impractical to be a realistic option. However, there could come a point, if bond yields falls sufficiently low, that cash becomes a viable alternative.
Investors may shift further along the risk spectrum, into corporate bonds, but even here negative yields are a growing presence. High yield bonds offer higher (positive) yields but with much higher risk than government bonds. Gold has historically served as a good store of value but has additional risk that investors need to be aware of.
All told, unless investors want to take on additional risk, bonds, even at negative yields are likely to continue to remain in demand.
[i] A yield curve shows the yields or interest available on bonds at different maturities. In theory it should curve upwards as yields should be higher as maturity increases reflecting the added risk of investing for a longer time period.
[ii] Buying assets in a foreign currency implicitly involves taking exposure to the movements in the exchange rate between the foreign and domestic currencies. If the foreign currency rises in value against the investor’s domestic currency, the investor will realise a gain when they convert the currency back, or will take a loss if the foreign currency weakens. Currency hedging effectively aims to remove this risk.
[iii] Source: EOPIA. Data as at 31 July 2019