Key insights:

  • The amount of global bonds trading at negative yields continues to rise and has accelerated recently.
  • There are a number of reasons why investors continue to hold and purchase bonds with negative yields.
  • Rate and credit volatility are likely to continue, offering opportunities for active fixed-income investors to source alpha and manage risk.

The amount of bonds around the world currently trading at yields below zero has grown substantially (see Chart 1). The total has more than doubled so far this year and jumped more than 18% since July 31, to reach nearly $17 trillion. With such significant growth, investors are rightly justified in looking for insight into how it is we have found ourselves in a world where nearly one-third of all investment-grade bonds trade at negative yields.

 

Chart 1: Total negative-yielding debt continues to grow

Negative-yielding debt rose more than $2.6 trillion in two weeks

 

For many investors, the mere concept of negative yields, in which the investor pays a borrower (most commonly a sovereign nation) for the opportunity to lend that counterparty money, is abhorrent. It feels like a violation of the nearly sacred contract by which a lender is owed interest from a borrower. Recently, this centuries-old concept has been swept aside as borrowers around the world are finding lenders willing to accept negative yields to loan them money.

 

How do you get a negative bond yield?

 

As we consider negative-yielding debt, it may be helpful to review an example of how an investor finds themselves owning debt with a yield less than zero. Illustration 1 below shows how a bond “achieves” a negative yield. It concludes with a decision facing many investors around the world today: What to do next?

 

Illustration 1: Negative yield explained

An investor pays 102.40 euros for a 10-year German Bund with a face value of 100 euros and a 0% coupon. The investor’s return is the total received at par less the price paid plus coupon payments. The annualized yield of this investment for 10 years is -0.24%. The investor faces a decision: What to do next? Accept negative yield and hold to maturity or sell the bond (at a higher price & lower yield)?


Why would someone choose to buy a negative-yielding bond?

 

There are a number of reasons why investors may consider investing in bonds with yields below zero:

 

  • Price insensitivity. Buyers, such as central banks, have been massive purchasers of bonds. They used quantitative easing programs to drive yields lower, encouraging investment and lending after the global financial crisis. Their chief concerns were achieving desired outcomes, rather than the price paid for the bonds. Similarly, regulators may force large-institutional buyers such as banks or insurance companies to hold bonds as capital buffers against other assets without concerns for the price of acquiring or holding those bonds.
  • Asset allocation. Other buyers may choose to invest in bonds with negative yields due to a lack of more attractive options. The positive yields on U.S. Treasury bonds may be less attractive than negative yields on German bunds to German investors once they consider the cost of converting their earnings from U.S. dollars to euros, for example. Risk-averse investors may consider the certainty of losing a small amount investing in sovereign debt a better option than the potential to lose much more in riskier assets such as stocks. Pension plans and long-term investors may look to lock in bonds with low yields in anticipation that yields could continue to go lower while other investors use bonds for the diversification benefits and low correlations to equities to complete their investment portfolios.
  • Alpha generation. Finally, investors may simply look to buy bonds with negative yields and find someone else to whom they can sell them at an even higher price (Choice B in Illustration 1 above). Bonds purchased with negative yields–that is, bonds with expected returns of less than zero–can still produce positive total returns. Table 1 below shows year-to-date total returns for sovereign bonds from around the world through August 22, 2019, along with their respective yields as of the same date. As you can see, despite yields being low or negative for these securities, investors who have held them in 2019 have had the opportunity for significantly positive total returns.

Table 1: Total returns can be positive despite low or negative yields

Even though sovereign bond yields are negative in France, Germany, and Switzerland, year-to-date total return is positive.

 

Many investors are wondering if yields on U.S. Treasuries could or will turn negative given the momentum driving bond prices higher around the world. The short answer is, yes, it is possible. There are no prohibitive, structural, or fundamental preventative measures keeping U.S. Treasury bond yields positive. U.S. rates are much higher than many other sovereign bonds, which could lead to increases in demand globally. If risk markets turn sharply downward, or if a strong flight-to-quality trade begins, Treasuries could benefit from that additional demand and yields could go lower.

 

Real yields (that is, nominal yields adjusted for inflation) have actually been negative on a regular basis in the United States. Chart 2 below shows the 3-month Treasury yield adjusted for inflation from 1920 to the end of July 2019. Almost 37% of the time the real yield has been below zero.

 

Chart 2: Inflation-adjusted yields have been negative 37% of the time since 1920

Chart showing real 3-month Treasury bond yield has been negative 37% of the time since 1920.

 

So although it’s possible, negative Treasury yields aren’t our base case in the short term. We believe the Federal Reserve (Fed) will be hesitant to drive the federal funds rate into negative territory, having witnessed the limited success of negative yields stimulating economic activity in Europe and Japan. The Fed may instead prefer to use additional quantitative easing, forward guidance, or other tools such as the reverse repurchase facility to keep front-end rates positive. The pending Treasury issuance required to fund the growing U.S. deficit (recently forecasted to reach $1 trillion in 2020) should also inject supply out the curve and put upward pressure on rates.

 

And it is possible that global appetite for negative yields is reaching a strained level. In mid-August, an auction for German 30-year bunds priced at negative yields failed as investors bid on €824 million out of a €2 billion offering.

 

What we do expect is continued rate and credit volatility as investors react to economic data from around the world to glean clarity on the direction of global growth. Concerns over trade agreements, the impact from tariffs, and the unpredictability of fiscal policy and corporate investment will also drive market sentiment and investment. Cautionary signals in the U.S. and abroad have been rising and may continue to send warnings to investors regarding the potential end of the economic cycle. This may be a difficult market for passive strategies who are forced to buy securities irrespective of yield levels or relative-value attractiveness.

 

Given this backdrop, we see opportunity. Market volatility breeds inefficiencies and pricing dispersion that active fixed-income managers like us may exploit to source alpha and manage risk for investors. Our portfolio managers, analysts, and traders are mindful of the historically low global yield levels. However, the breadth and depth of our global fixed-income platform allows us to look for relative-value opportunities across the globe, across markets, and across currencies for our investors.

 

All investing involves risks, including the possible loss of principal. There can be no assurance that any investment strategy will be successful. Investments fluctuate with changes in market and economic conditions and in different environments due to numerous factors, some of which may be unpredictable. Each asset class has its own risk and return characteristics. Bond values fluctuate in response to the financial condition of individual issuers, general market and economic conditions, and changes in interest rates. Changes in market conditions and government policies may lead to periods of heightened volatility in the bond market and reduced liquidity for certain bonds held by the fund. In general, when interest rates rise, bond values fall and investors may lose principal value. Interest rate changes and their impact on the fund and its share price can be sudden and unpredictable.

 

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