Negative Yielding Bonds: Not All Heroes Wear Capes
I’m here to make you an offer. You lend me £100 and I’ll pay you back £90 in ten years’ time… sound good?
Your answer should be no! This is what many highly paid and reputable portfolio managers are doing with your parents’ pensions right now… losing money. To understand why this is happening, let’s make sure we’re on the same page by reviewing some key concepts - bonds and yields.
What is a bond?
Have you ever wondered how governments can seemingly never run out of money? Well, as long as they can afford the interest payments on their loans, they can keep on borrowing and increasing their budget deficit. When a government wants to raise money, they issue bonds. Bonds are a form of debt that is required to be paid back over different periods of time, from a few weeks to several decades. Unless something goes seriously wrong (like in Greece and Argentina) and the borrower defaults on their debt (essentially goes bankrupt), you will get a return on your investment. Interestingly, if America ever defaulted on their debt, it could be the end of capitalism as we know it. However, since the United States issues its debt in its own currency, it could just print money to pay it off. So, the question you should be asking is, what will happen to their currency if they ever default.
How do bonds work in practice?
The issuers of the bond, for example a government, will make regular interest payments to those who hold them over their life span. This fixed rate of return that investors receive on a bond is called the coupon. On top of this, there is an extra component called the yield which is a payment as a proportion of the price. In other words, a bonds coupon rate is the rate of interest it pays annually, whilst its yield is the real rate of return it generates. There is an inverse relationship between the price of the bond and the yield. This means that, as one increases, the other decreases. For example, if the price decreases, the yield will increase.
Why are bonds yielding negative rates right now?
In the last decade or so, developed economies have suffered from low growth and low inflation. So, to encourage people to spend more money, central banks (including the European Central Bank (ECB), Federal Reserve (FED), and the Bank of England (BOE)) have been reducing interest rates whilst simultaneously injecting money into the economy through quantitative easing to encourage spending. Idle money will do nothing except lose value due to inflation, so the only options are to spend it, boosting the economy, or invest it in risker assets such as equities or currency. The same idea is applied to banks. The ECB now charges other European banks nearly half a percent interest to hold their money in their deposits! The banks are effectively being taxed for holding money. This encourages banks to lend their money out into the economy, further promoting economic growth.
Furthermore, wealthy investors such as large insurance companies and pension funds, face a poor economic outlook, plagued by rising unemployment and the looming uncertainty of the upcoming U.S. presidential election. Bond prices have been skyrocketing because investors see bonds as one of the safest assets. However, this increase in demand makes them more expensive, consequently lowering their yields. Prices have currently reached new highs which means the yields in several countries such as Austria, Belgium, Finland, France, Germany, the Netherlands and Switzerland have turned negative. This means investors will receive less than they paid if they hold the bond to maturity (its expiry date).
Why should you care?
A negative yield means investors are receiving less money than they originally paid. Currently, approximately a fifth of the bond market trades with negative yields. This means that issuers of debt (such as governments) are now being paid to borrow and the investors, or buyers of bonds (other governments or wealthy investors) are paying these borrowers instead of receiving an interest payment. Despite this, bonds provide reliable returns which makes them one of the safest investments on the market meaning a well-balanced portfolio must contain them. Government bonds (such as British GILTS, American Treasuries and German Bunds) are considered very safe assets because governments are considered reliable borrowers. They have wealthy citizens who pay taxes, which are used to pay the interest payments on the loans. The owners of these bonds can also buy and sell them in a secondary market similar to the stock market. This makes these bonds very liquid which means they are easily sellable.
It is important to stop and consider this bond market. What will happen when the bonds stop increasing in value and the economic outlook improves. Who will be stuck with these expensive, low yielding bonds? Probably small-time retail investors.
A bond is considered a safe investment since it provides positive real rates of return, above the rate of inflation. Inflation being the amount by which money depreciates over time… remember how much a Freddo bar used to cost? This has sparked a recent debate about whether negative yielding bonds should be considered safe havens at all since they are not providing positive returns. In fact, some investors are refusing to own negative yielding bonds for this reason. However, investors such as banks, insurance companies and pension funds have no choice. They must ensure their funds are liquid and when borrowing they can also pledge bonds as collateral.
It depends. If low growth, trade tensions and political uncertainty continue, investors are likely to continue to flock to safer assets, like government bonds, thereby driving up prices and keeping yields negative. In fact, the volume of negative yielding bonds has started to fall, but some market experts believe that by 2022, a fifth of sovereign bonds will have a negative yield.
How does this affect you?
In the short term, negative yields can stimulate the economy. However, over a longer horizon, negative yields could mean lower returns on pension funds meaning workers could be forced to save more and work longer. With the current retirement age at 67 and with plans to increase it… imagine working until you are 70! The central bank’s strategy could help the economy in the short term, but over a longer time frame negative yields could slow down the economy even more making themselves prisoners of their own policies.