Negative Bond Yields
Updated: May 1, 2020
The concept of negative interest rates and bond yields was not really part of investors’ consciousness until recent years. The recent downgrades to the economic outlook, central bank rate cuts, and collapse in longer-term rates has put the issue front and centre for all investors.
Paying for the privilege of lending someone money is a hard concept for many to get their head around. Earning a return on capital is the cornerstone of the capitalist system. From an investor’s perspective, buying a bond with a negative yield, guarantees a loss if the bond is held to maturity. And this is before inflation. If we assume inflation stays somewhere close to central bank inflation targets, the losses on these securities in real terms will be even greater. This is reflected in the deeply negative real yields on inflation-linked government bonds that have prevailed in the UK and elsewhere for years. The fact that the universe of nominal yields around the world that are now negative is now swelling, grabs headlines but is just the latest chapter in a long running saga.
The growing presence of negative nominal and real yields underscores the scale of the horrors facing investors requiring safe returns in the future. The return on a 10-year bond yielding -0.50% is (drumroll) -0.50% per annum. If you buy a 30-year index linked gilt at its current real yield of -2% and hold it to maturity, every £100 is guaranteed to lose almost 50% in real terms over the next 30 years. Risk free. The fact that yields have been continually trending lower means that investors have been cushioned (in the short-term) by capital gains on their bond portfolios and hence returns have been great. The pain has yet to be felt. However, the mathematics guarantees that these capital returns are all stolen from the future.
Why would anybody buy something that is guaranteed to lose money? Believe it or not there are quite a few reasons. Firstly, they are forced to by regulations. This is something that has become increasingly prevalent with new capital adequacy requirements that apply zero risk weight to sovereign debt. The scarcity of these “safe assets” relative to demand means that yields are forced to previously unimaginable levels.
Secondly, there is the issue of opportunity and risk tolerance. For some, the certainty of a small loss might be preferable to taking the risk of a much bigger one. On the face of it, an individual should stand ready to borrow unlimited amounts at negative rates as they would get paid to do so. But what to do with the money? The requirement of the banking system to earn a spread means that deposit rates will be even more negative than the borrowing rate. Hence, the borrower must use the funds in a venture with a degree of risk or invest in a higher risk asset. The fact that rates are where they are is an indication that entrepreneurs are not seeing a wealth of opportunities and that other financial assets are not oblivious to where rates are, and are priced accordingly. The other angle is that much of the economy is already up to its eyeballs in debt and may have limited appetite for more at any rate of interest.
One sector that could be coaxed into taking the bait of negative rates is the corporate sector. Many large corporates can now borrow at negative rates. For an already wealthy CEO, with compensation largely linked to share price performance, borrowing at negative rates to buy back stock, with a positive impact on cash flow and earnings per share is a no brainer. If things go wrong down the road due to over-gearing it will be someone else’s problem. If rates continue to fall, corporate executives will be incentivised to LBO the entire stock market at almost any valuation. Negative dividend yields anyone?
Thirdly, investors are expecting prolonged and persistent deflation that will convert negative nominal yields into real, inflation adjusted gains. For this to materialise we must believe central banks will fail spectacularly in meeting their mandates when in extremis, they have almost unlimited power to avoid this. As an aside, given the impact this would have on the real value of the already unprecedented global debt burden (first higher and then much lower through an avalanche of defaults) and resulting economic chaos, we can safely assume that this eventuality will be avoided at all costs.
Fourthly, there is the greater fool trade. Investors/speculators buying bonds at negative yields with the plan of unloading them to other investors at even more negative yields. This has the whiff of a tech-boom style bubble brewing in the bond market and it is a valid question to ask: Is the bond market a bubble that will eventually burst? Our answer to this question is: absolutely, but not in the way traditional way. The bursting of the bond bubble via falling bond prices/higher yields would be the end of the world as we know it. The higher rates this would imply are simply not viable due to ubiquitous leverage. Instead, central banks in control of fiat currencies will backstop bond markets with printed money in perpetuity. Sovereign debt holders won’t lose a penny. It’s just that when those pennies are returned in coupon and principal, they won’t stretch anywhere near as far as the holder once thought they might. Same for cash.
Global Negative Yielding Debt