The bond markets have ushered in an era of negative interest rates, confounding the long-held belief that zero constituted a lower bound for yields. At the beginning of March, nearly 17% ($3.85 trillion) of developed market global government bonds traded at negative yields, with several trillion more – mostly in Japan – trading marginally above zero. Investors must extend beyond a seven year maturity to receive a positive yield in Germany. They must buy a 12-year bond before escaping sub-zero yields in Switzerland.
Have bond investors lost their collective minds? Paying someone for the privilege of holding your money certainly defies logic. There are, however, some valid reasons why fixed-income buyers might accept negative rates:
1) deflation (or the fear of it), that would help produce a positive real return, 2) speculation on currency appreciation, 3) financial repression, in which an investor is either forced to own such assets or discouraged from holding cash, 4) price insensitivity, as might exist when a central bank’s purchases are driven not by profit incentive but by policy initiative, 5) arbitrage, present in some markets such as Denmark or Sweden where there is high degree of confidence that policy rates will remain negative for a long period of time, and 6) rules-based buying, as is the case for index funds.
Low for long
Persistent low real rates hurt savers, forcing them to save more for longer to meet their financial objectives. For others, it may force a move into more risky assets, which would compound the problem if a bear market unfolds. This could create a vicious circle in which policymakers would possess few weapons.
For defined benefit pension scheme sponsors, the implications of low or negative bond yields can be catastrophic, as the present value of long-term liabilities is usually calculated by reference to a long bond yield. Low or negative yields create a dilemma for an underfunded pension. They can reduce funding gap risk via additional bond purchases at record low yield levels. Alternatively, they could increase risky assets but be heavily exposed to a severe market correction.
How should investors respond?
Today’s environment should be supportive of other high-quality income producing assets – investment grade and high yield are among the obvious beneficiaries of negative yields, as are higher-yielding equities and commercial property. Bond investors will be pushed further along the yield curve and down the credit spectrum, potentially exacerbating problems when interest rates do eventually rise.
We expect yields in Europe and Japan to remain relatively depressed, but no investor today should embrace longer-dated sovereign bonds as “safe assets.” Ten-year German bunds yielded 1.56% only one year ago. A return to those levels in the next 12 months would generate a -10.8% return. A similar yield increase in 30-year German bunds would lead to a whopping 20% loss.
The asymmetry of returns remains the biggest worry for sovereign bond investors. The degree to which investors can earn modest positive returns but suffer from deep negative returns makes for a challenging risk/reward trade-off.
Market participants are accustomed to the possibility of losing money – it is a risk assumed in the pursuit of positive returns. Certainty of losing money, however, is another matter. This is a strange, new world.
