When yields turn negative, fundamentals are tested
May 18, 2015
On April 8, 2015, Switzerland came to market with a bond issue bearing a 1.5% coupon and a maturity date of July 24, 2025. In the secondary market, the issue closed with a yield of -0.055%. As the negative yield would suggest, appetite for the bonds was unusually strong as investors bought 232.5 million Swiss francs’ worth (and a notable 26% of orders came from foreign investors). Elevated demand for government debt was also expressed elsewhere: Prior to the Swiss issue, in the month of March alone, 11 European countries saw the yield on 2-year government debt close below zero and remain there for at least 10 trading days.
From a central banking perspective, negative policy rates are essentially a tax on savings as bank officials look to make saving less attractive while promoting more investing. From a sovereign debt perspective, negative rates imply that investors prioritize government bonds as avenues for storing wealth, even if that means overlooking other, more traditional options. So, when we look at this combination of events, we see a landscape in which the fundamentals of investing are being tested, especially as Europe wades through a highly unusual situation in which investors are willing to accept negative yields on sovereign debt even when positive yields are available elsewhere.
How did we get here?
We believe the existence of negative yields on sovereign debt reflects the unprecedented and extraordinary monetary easing policies being put forth by national banks. In January, for instance, the Swiss National Bank lowered its deposit rate to -0.75%. Other European central banks followed suit, moving interest rates to unusually low levels. We also watched a string of other important developments, all of which happened within the first three months of 2015. Two stand out:
- Denmark eased its deposit rate several times, eventually reaching -0.75%.
- Sweden’s Riksbank lowered its repo rate* to -0.25% and expanded its quantitative easing program to 30 billion kronas.
How extensive is the negative yield problem?
Based on the Citigroup® World Government Bond Index, the amount of European sovereign debt with negative yields amounts to approximately 9.54% of the global market value (in U.S. dollars, as of April 10, 2015 — see table). This market segment is growing, and we are leery about this growth because negative yields typically push a market to become less liquid and more volatile.
Some of the practical ramifications that we are concerned about involve local banks; pension and insurance asset managers; and reserve managers. All in all, we think institutions like these will be less likely to adjust their holdings amid the constraints of such a market. (This means they could lose some flexibility within their portfolios, which can be deeply troubling for any company, but is particularly burdensome for financial services firms.)
Meanwhile, in the realm of corporate debt, the prevalence of negative yields is not as pronounced, but we think it still bears monitoring. Within the Barclays Global Corporate Index, approximately $24.7 billion in corporate debt is in negative-yielding territory, amounting to 0.326% of the overall market. (As an aside: Given the extremely unusual nature of bonds that have negative yields, we wonder if investors — especially those who hold bonds to maturity — are adequately aware that they are essentially paying someone else to hold their money for them.)
Will these abnormal circumstances pass quickly, or will they last? The answer may depend, at least in part, on the European Central Bank’s (ECB) monthly commitment to buy 60 billion euros’ worth of bonds well into 2016. Ultimately, the ECB’s purchases will amount to 1.14 trillion euros' being injected into bond markets, and we think this long program of systematic purchases could very well usher in an era of erratic and atypical bond-market behavior.
Perhaps most troubling to us is that the pool of negative-yielding debt could very likely continue to grow. While we would think that the top of an asset bubble would be upon us by now, there is reason to believe that bond prices could actually continue to inflate. We think it's realistic to expect negative yields to be an issue in fixed income markets for some time to come.
Bonds at negative yields: A growing slice of the market
Percentage of bonds within the Citigroup World Government Bond Index with negative yields
*The repo rate is the rate at which the central bank lends money to commercial banks when they experience a shortfall of funds.
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IMPORTANT RISK CONSIDERATIONS
Investing involves risk, including the possible loss of principal.
Past performance does not guarantee future results.
The Citigroup World Government Bond Index measures the performance of fixed‐rate, local‐currency, investment grade sovereign debt from 23 countries.
The Barclays Global Corporate Index provides a broad measure of the performance of corporate bonds issued globally. The index comprises more than 12,000 individual issues, with an average credit quality toward the lower end of the investment grade spectrum.
An index is unmanaged and one cannot invest directly in an index.