Do we have a deal for you! How would you like to loan some of your hard-earned money to the German government for the next 10 years and, in return, receive absolutely no interest for the use of your capital? No, not interested? Well then, we highly doubt you’d be interested in earning a negative return to allow Germany to tie up your capital for the next 10 years. Believe it or not, there are investors out there who have wasted no time to take advantage of this deal.
On July 10th, Germany issued €7 billion of debt at a yield of -0.26%. To buy €10,000 in par value of those bunds (that’s German for “bonds”) you would have to pay €10,264. To clarify, you would pay €10,264 now for the right to have the German government pay you €10,000 in 10 years – and you wouldn’t receive any interest in between. If that’s not bad enough, on July 31st, 10-year German bunds offered an even worse yield of -0.44%. This phenomenon is not limited to German bunds mind you. Take a look at the following chart that shows a sample of countries which currently have two-year bonds with negative yields.
Source: Bloomberg/Cowan Asset Management
It is estimated that more than 30% of the world’s sovereign debt now trades at negative yields. Looking at the next chart, on July 31st, more than US$14 trillion (that’s 12 zeros!) of debt traded at subzero yields. Even some corporate bonds are getting in on the action: Nestle (NESN-SWX) has short bonds that provide a negative yield to maturity. Torsten Slok, Chief Economist at Deutsche Bank Securities, estimates that US$600 billion of corporate debt now carries negative yields.
Source: Bloomberg Barclays Index data
Heck, in Switzerland, the entire yield curve (i.e. the yield offered on bond maturities from 3 months out to 50 years) is solidly below zero, as shown below.
Source: Bloomberg/Cowan Asset Management
All of this may seem counterintuitive, as one of the most basic economic concepts is that there is a cost to borrow money and, therefore, one should be compensated to lend money. So what is the goal of this extraordinary monetary policy? Put simply, negative interest rate policy by the central banks is meant to incentivize banks to lend money rather than holding excess reserves on deposit with the central bank. By extension, it pushes businesses and individuals to spend money rather than pay a penalty in order to keep it sitting at their bank. This is all an attempt to stimulate spending and growth and stave off falling prices. Japan and much of Europe have been experimenting with negative yields for quite some time, but so far, the jury is out on their level of success, as economic growth has remained tepid and inflation subdued.
The key risk to this type of policy intervention is that it could create a liquidity trap, a situation where despite low interest rates, the savings rate remains high. Essentially, investors would prefer to hold cash because they expect asset prices to be cheaper in the future. This dynamic renders monetary policy ineffective, as no matter how cheap it is to borrow, investors would prefer to leave their money in the bank (or under their mattress). The situation has been playing out in Japan since the 1990s where despite negative interest rates, investors have chosen to save versus spend and invest. Thirty years after touching its all-time closing high of 38,916 in 1989, the main Japanese stock index, the Nikkei 225, is trading at only 55% of that peak value.
The growing number of negative-yielding bonds is the result of central banks across the globe loosening their interest rate policies, even in the face of historically-low interest rates. The driving force behind these operations is the slowing global economy and rising fears about trade wars.
One side effect (or perhaps the real goal of loose interest rate policies in some countries) is a devaluation of a country’s currency, which makes a country’s exports cheaper to foreign buyers. Unfortunately, it’s not hard to see that this could become a race to the bottom. The U.S. President has jumped in on the action and has not been shy about suggesting that the U.S. dollar is overvalued and that the Federal Reserve should intervene to devalue the greenback.
Bond prices are determined by supply and demand, so clearly someone is buying
You might be wondering who would actually buy negative yielding bonds. Never say never, but it’s not likely to be Cowan Asset Management. Here is a list of some of the possible buyers:
- Investors who think that despite yields being negative they will fall even more (causing bond prices to rise).
- Investors who prefer a small loss in fixed income rather than risking a larger loss by investing in equity markets.
- Traditional balanced (i.e. 50:50 equity/fixed income) investors who are content with below-zero yields as long as the stock market keeps rising and expect their bond holdings to help offset any equity weakness.
- Certain institutional investors, like insurance companies and pension funds, that may be mandated to hold a certain percentage of their portfolios in local government bonds or to match their liabilities to assets, meaning they don’t really have a choice but to accept negative yields.
- Large investors that need the reliability and liquidity that government bonds provide, with relatively few other options available.
- Many of the countries with negative yielding debt are also running quantitative easing programs, so their central banks are buying the negative yielding debt and aren’t terribly concerned about what the yield is.
So far, negative yields have mostly been a European and Japanese phenomenon, but despite yields in North America remaining well above zero, it’s not out of the question that North America could one day be subject to the same outcome. A number of industry observers are now saying that the probability of U.S. treasury yields turning negative is significantly higher than zero. You can see one such discussion here. The thought is that over the coming years a recession caused by a protracted trade war could push the Fed to cut rates back to zero and restart their quantitative easing program. The combination of these actions would likely push treasury yields into negative territory. Given the interconnectedness of the U.S. and Canadian economies, it’s safe to assume that if U.S. yields turn negative, Canadian yields wouldn’t be too far behind.
For those who keep a close eye on this sort of thing (like your investment team at Cowan Asset Management) the yield curve has actually been on a rollercoaster ride over the last year. When global and local economic growth started to pick up about a year ago, central banks took a more hawkish tone and slowed their stimulus policies by raising interest rates, which, in turn, caused bond yields to rise. Around the end of 2018, however, concerns arose about trade wars and slowing growth in the global economy. Bond yields subsequently fell as it looked like central banks may once again have to loosen monetary policy.
To see what this all looked like in practice we can turn to the yields on the U.S. and Canada 10-year bonds. Three years ago, in July of 2016, the 10-year U.S. bond hit a modern-day low of 1.35%. It would spend the next two years steadily rising to a high of 3.25% before hitting an inflection point and falling back to 2.0%, which is where it stands today. The 10-year Canada bond followed a similar path, starting at 0.95% before rising to 2.6% and then eventually falling back to the 1.50% level of today. Now, as the volume of negative-yielding debt grows across Europe and Japan, investors are treating the positive returns offered by U.S. and Canadian bonds as a safe-haven, which is further exerting downward pressure on yields.
Source: Bloomberg/Cowan Asset Management
Not Your Father’s Bonds
North American investors need to get used to the idea that government bonds may no longer be the reliable, income-producing assets they once were. As yields approach zero or turn negative, there is likely a lower bound for yields, which would represent the level where demand wanes. If this theory is true, it means that bonds won’t be able to provide the same cushion in the event of a prolonged downturn in equities as they did in the past. It also means that investors will have to reset their expectations for what is a reasonable rate of return. For example, if an investor held a balanced portfolio (i.e. 50% equities and 50% bonds), even if the equity portion of the portfolio returned 7%, a sub 1% return on the bond portion would mean an overall portfolio return below 4%. Unfortunately, this dynamic tends to push investors, especially those at or near retirement, to take on more risk than they should in order to make up the difference.
Ever since the financial crisis it has become increasingly difficult to find bonds that offer a decent yield. Despite these difficulties, we believe that the Cowan Income Opportunities Fund provides a solution for an investor’s fixed-income needs. In the Fund, we look across the entire fixed-income spectrum to find securities with attractive yields. In addition to government bonds, we invest in corporate, high yield and convertible bonds, along with preferred shares. We also keep an eye out for mispriced securities and special situations where we believe the portfolio can benefit from a material increase in the price of the security while also collecting an attractive income stream. For perspective, despite the 10-year Canada bond yielding only 1.5% at July 31st, the Cowan Income Opportunities Fund was generating a yield above 5%. We believe this is attractive, given that more than 20% of the Fund was allocated to cash securities earning just 1.9%.