Bonds are traditionally used within investment portfolios to reduce equity risk and generate income through the yields they carry. For example, a 10-year bond with a face value of $10,000 with a 5% yield generates $500 in income. Most recently the US 10-year yield was 1.5%.
However, over the past few years central banks in Europe and Japan have experimented with Quantitative Easing and driven rates below zero%. In August 2021, the amount of negative yielding bonds reached over $16.5 trillion. In May 2019 that amount stood at $12 trillion. Yields in Europe continue to fall as the ECB in June indicated its plans to set up a new bond buying program in upcoming meetings. A slow-down in the European economy, spiking energy prices and rising inflation has left businesses and economists frustrated. (1)(2)
What is a negative yielding bond? It is a bond with an inflated value and a yield of less than zero%. An example of a negative yielding bond is one with a face value of $10,000 but a market value $11,000. The purchaser of such a bond literally pays more than the bond worth for the right to own the bond. As bond yields move down the value of a bond increases. As bond yields move up the value of a bond decreases.
As energy prices and inflation has risen, bond yields have quickly moved higher. As a result, the amount of negative yielding debt has decreased, and the value of bonds held by central banks and institutional investors has plummeted.
Negative yielding bonds is a new phenomenon.
In a fascinating interview on Bloomberg Surveillance on 7/2/2019 Jim Caron, Morgan Stanley fixed income portfolio manager talked with Tom Keene and John Ferro. (3) The conversation succinctly outlined the challenges generated by negative yielding bonds.
Tom Keene asks, “(For Italy), how is a negative 2 year yield possible?” Italy has long suffered with ballooning budget deficits and an excessive debt load. Many investors view Italy as a riskier place to invest, compared to stronger economies such as in Germany, the UK, or the US. Because of that risk, investors typically expect to be compensated with a higher yield to hold the debt as an investment.
John Ferro adds, “That’s insane isn’t it?” Caron responds, “Yes, I think so, Italy is in a special situation…”
John Ferro asks “looking at the front end of the yield curve we have negative yields in Italy, deeply negative in Germany, its been that way for the last few years. The fact of the matter is the depo rate in Europe is -.40bps, and that’s just keeping a lid on any potential upside on the front end of the yield curve… is that going to change any time soon?”
Caron answers, “No, I don’t think it changes any time soon, in fact it might get a little bit worse.”
Tom Keene injects, “None of this is in fobse(how finance people are trained), can you explain coming out of this… the reaction function coming out, can you presume financial stability?”
Jim Caron answers, “No, I think there is a very strong challenge here and we all have to recognize that we are in a global liquidity trap, meaning that you can lower rates another 50 bps, another 100 bps, and you are not going to get economic activity. It used to be when you lowered rates you increased the demand to borrow, because you could borrow at cheap levels, then you could go and reinvest. The problem we are having today isn’t that banks won’t lend, it’s that borrowers won’t borrow, we call that a balance sheet recession. Essentially what we are seeing is the potential growth rate is low enough that you are not seeing a return on an investment required. So what people are doing is they are holding high levels of cash, and as they hold high levels of cash yields continue to come down.”
“The demand for income is massive,” says John Ferro. “Commerz Bank came out with a new contingent convertible bond, oversubscribed at a juicy yield of 7%…”
Caron responds, “So look 7% sounds really good, but you have to look at the risks that are associated with that… and to Tom’s point about financial stability, when you get yields this low you end up taking more and more risk with lower quality risk just to get any type of yield. This typically doesn’t end very well.”
Caron asks, “If lowering rates doesn’t generate economic activity, then why would they create a situation where they end up creating more risk taking in lower quality assets?”
“Should we be worrying more about the liquidity risk people are being pushed into because of the lack of yield, the lack of income?” asks Ferro.
“The liquidity you are talking about is if you are buying some of these higher yielding, lower quality assets, when it comes time to sell its going to be hard to do that… I think that is an increased risk because what investors are not realizing is they are getting that yield because they are shorting the risk premia… in times of stress that can create bigger problems.”
“Sounds like late 2006…” asserts Keene.
“From an investors perspective I am not going to go out and try to get a little bit of yield and take on liquidity risk because its just not worth it in the end…” adds Jim Caron.
Tom asks pointedly, “When we come out of negative yields and what happens when we cross zero into a positive yield? Am I right… do we really not know?”
Caron answers, “Yeah, we really don’t because essentially a lot of people have been forced into these low levels of yield. Rule number one as a fixed income investor is don’t lose money. The potential to lose money in fixed income is very very high. The more you push these yields down and the less cushion you have typically from a coupon you get on a bond, the more risky it is that when yields rise you will experience a loss.”
“The bigger issue we have right now is because yields are so low they actually become highly correlated with equity so if you are trying to run a diversified portfolio, typically 60% stock, 40% bond, ones supposed to go up when the other goes down, what ends up happening (now) is they both move in the same direction. So the risk you are talking about is higher than you think.”
Most investors are unaware of the dynamics at play in bond markets today because of negative yields. To use Ken Rogoff’s phrase ‘This time really is different’, because we have never experienced a market downturn when bonds had negative yields at the start of the crisis, let alone during or by the end.
Issues arise from illiquidity when investors try to sell an asset that is quickly depreciating during a sell off. Issues also arise from the fact that markets count on the central banks stimulating markets by lowering interest rates… what happens if that tool is not effective as Caron discusses above?
Examples of such illiquidity and risk taking turning out badly can be seen today in China’s high yield debt and real estate markets that are plummeting in value as investors unload investments. The cash flow issue affecting Evergrande has spread to other companies involved in Chinese real estate development. Another developer, Fantasia, defaulted on a bond on Monday. Sinac Holdings has warned it will default on a bond that comes due next week. Other companies are struggling to extend maturities and avoid default. As bond values plummet, yields spike higher, and it becomes difficult to find buyers… markets become less liquid, and this negatively affects other healthier industries and investors. (4)
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