Businessman with yellow insurance umbrella looking over city

This article appears in the April 2020 issue of Investment Executive. Subscribe to the print edition, read the digital edition or read the articles online.

In bonds, the financial crisis is manifest. Shorts — treasury bills sold at discount and due in a year or earlier — are holding up well.

For example, Canada sovereigns due in 365 days or earlier tracked by iShares XSB ETF were down by just 2.4% for the six-month period ended March 18. The slight decline was a retreat from enthusiasm or fear the week before, when T-bill prices rose a bit too high. But the bond market is far better than that of shares. Stocks in Canada and the U.S. have lost 20% or more of their value vs the end of 2019, depending on your choice of index.

The stampede to safety is evident in U.S. treasuries, which, in addition to certainty of payment, have the greatest liquidity of any financial asset in the world. On March 26, two-year T-bill yields were 0.30%, down from 0.84% at the beginning of March, while 10-year T-bill yields were at 0.83%, down from 1.10% at the top of the month. Yields, of course, move inversely to price. Investors are choosing cash-equivalent shorts over longer, better-paying bonds. Liquidity, not yield, is the goal.

In Canada, the process is the same. At the March 25 auction, federal three-month T-bills dropped their yields to 0.49% from 0.64% two weeks earlier. Six-month T-bill yields dropped to 0.45% from 0.58% two weeks earlier, and one-year T-bill yields dropped to 0.44% from 0.55% two weeks earlier and from 1.64% at the beginning of February.

The scale of the problem is the “fear” premium. Stocks’ value depends on investors’ views of future earnings, sales, debt levels, and more. For government bonds, tax collections underlie ratings and rates. Whether Canadian and U.S. T-bills go to negative yields, as many European bonds have, is both a political matter for policy-makers and the practical matter of providing banks with liquidity.

Bonds’ interest payments reduce the theoretical cost of buying safety. But dropping yields have driven up the cost of that safety. Negative yields mean the insurance premium between corporate bonds’ or longer-term government debt’s positive yields and short-dated bonds’ negative yields is rising. Longer bonds that pay at least part of their way with higher yields have a lower insurance cost, but they have higher price risk in their longer durations. And subnational bonds and corporates with still higher yields pay even better, but make less credible promises of principal repayment.

For now, the mantra is safety and the intrinsic insurance costs of the most secure bonds don’t seem to matter. “Bonds now have less shelter if we start from a low-yield environment,” says Avery Shenfeld, chief economist with Toronto-based Canadian Imperial Bank of Commerce. “That makes sense, [as] longer bonds have less shelter value.”

Where we go from here is the issue. Precaution underlies much of the drive to low and negative rates on government debt. “What we know is not about fundamentals, but about fear,” says Chris Kresic, head of fixed-income and asset allocation with Jarislowsky Fraser Ltd. in Toronto. “Investors are buying liquidity at any price. The trading is so one-sided at times that market-makers are using derivatives to make trading work.”

In this angst-driven market, liquidity, not return, is the concern. The lower rates go, the more households hoard cash. That cash pays little or even less than nothing is not the point. But to maintain income, savings are rising. According to a Bloomberg LP report on March 17, household savings in Germany have reached 11.2%, the highest percentage in a decade. The report also notes that savings rates in Denmark and Sweden are near all-time highs. Rather than getting people to spend more, low and negative rates are pushing people to save more in order to maintain their spending power.

For now, the mood of the bond market is protective. An investor who just wants to speculate on rate cuts can add duration risk by buying long bonds. “If you believe that there are rate cuts coming before we get to zero, then you can buy long bonds outright,” notes Michael Gregory, deputy chief economist with Bank of Montreal in Toronto. “If you have strong conviction that the recent [rate] cuts are not the last of the [U.S. Federal Reserve Board] and Bank of Canada moves, you can make gains if they do cut.”

Other investors are making these bets, too. With near-zero yields on government debt, the market is now being run for speculation, not income. Risks, especially in long bonds, are immense. When the coronavirus abates, as eventually it must, there will be a rush to equities paid in part by sales of bonds. There is little safety in overpriced assets primed for a drop.