The global bond market is moving into a territory seldom experienced: negative nominal interest rates on short-term bonds. Although bizarre, this trend is a sign of the times – and it calls for new tactics in bond investing.
Much of the blame can be put on quantitative easing (QE), which is forcing bond yields down, or deflation, which is spreading across Europe and parts of Asia. In Germany, a two-year bund pays minus 0.2% to maturity. In Japan, a two-year sovereign bond pays precisely 0% to maturity. Go out 30 years and the yields are 0.97% and 1.5%, respectively. The most extreme major currency sovereigns’ negative return is Switzerland’s return of minus 1.2% for two years.
Nobody buys into government debt for these returns. Instead, they buy for bond price appreciation.
Negative interest on deposits is not new; in fact, Switzerland’s banks are famous – or, if you prefer, infamous – for charging for the storage of money. But the concept of charging for the storage of money with bonds is consistent with the new world of bond investing, in which interest turned negative is a cost, not a gain.
The idea of signing on for a guaranteed loss seems irrational until you consider what’s being gained. First, there’s liquidity in sovereign bonds and a rock-solid guaranteed return of a known sum after a tad of value is lost to the market. Then, there are possible currency-exchange gains. And, finally, there is the belief that if deflation does break out, the purchasing power of the bonds – minus the interest paid for the privilege of owning them – will rise.
If even some of that happens, it will be a case of prophecy turned into reality. Ultra-low interest rates generated by central banks are being used to stimulate economies, although with uncertain results.
However, for bond investors, strategies for capturing yield advantage are rather clear. As Edward Jong, vice president and head of fixed-income with TriDelta Investment Counsel Inc. in Toronto, notes, there is a spread of approximately 131 basis points in going from a 10-year German bund, payable in euros with a 0.34% return to maturity, to a U.S. Treasury 10-year bond with a 1.76% yield to maturity. The currency-exchange risk is entirely on the side of the euro, which is likely to decline, so being invested in U.S. dollars is smart on both the yield and the currency sides.
Bond investing now is a game of capital gains or losses, not interest yield. In fact, the 30-year Government of Canada bond yields 1.87% to maturity while the 30-year U.S. Treasury bond yields 2.13% to maturity. The concept of signing up for such returns seems irrational; but if inflation drops enough, those returns look good.
What’s next is the question. The European Central Bank (ECB) announced on Jan. 22 that it would buy 60 billion euros worth of government and corporate bonds a month through September 2016, at least – and maybe for as long as it takes to reflate Europe’s economies. The ECB’s QE program is going to push up bond prices, which will depress yields even further. The theory is that banks, flush with bond gains and hoped-for stock gains, will lend more and businesses will reflate Europe’s economies.
Deflation, the beast that seems to be stalking Europe’s economies, is thriving on low expectations of global growth. Global capital markets have been roiled by declining rates of growth in several European nations’ gross domestic products. In fact, eurozone inflation fell to minus 0.56% in December 2014, according to Bloomberg LP reports.
However, for clients who are invested in bonds, low growth is a good thing – it implies further declines in interest rates, which will push up the prices of existing bonds. Corporations have happily co-operated with the low-growth scenario, taking advantage of low interest rates to issue more bonds. In the real world of normal economics, a financial system slowdown would imply slowing or declining stock markets; but that has not happened yet. Stocks, especially those that pay dividends, have thrived, in part because dividends are higher than bellwether 10-year bond yields.
Negative interest rates alone have not undone conventional bond price and return relationships, notes Chris Kresic, senior partner and head of fixed-income for Jarislowsky Fraser Ltd. in Toronto. “Negative short rates have steepened the yield curve,” he says. “Strip bonds still have their payoff at the end of their terms. Yet, it is what happens in between the short and long ends that has changed.”
Negative yield implies higher duration as the time to recovery of principal is lengthened. That implies more risk, which, in turn, means that clients who take on bonds with no meaningful cash flow or negative yield are taking on more than the customary risk for a bond of similar term that pays positive interest. The zero cash flow or even negative cash flow bonds become, in effect, high-duration strips.
Bond prices are likely to continue to rise on momentum alone. Investors’ disbelief that the bond market will accept negative interest bonds has been overwhelmed by the rush to buy more of them.
Such momentum investing recalls the 17th-century Dutch tulip frenzy. When inflation returns, as it will one day, high-duration, negative-yield bonds will crash.
In this poker game, these cards already have been dealt.
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