Leader Capital Weekly:

What Are the Investment Implications of Negative Yields?

By Ben Emons | March, 2016

Negative yields on bonds are no longer unicorns. In Switzerland, Germany, Denmark and several other European countries, government bonds are trading at negative nominal yields. Just last week, the Bank of Japan announced it is adopting negative interest rates. For investing, there are four potential reasons that can illustrate trade-offs between different investment strategies as a result of negative interest rates.

First and foremost, negative yields could simply be a consequence of active monetary policy (with the expressed goal of stimulating economic activity) in a world where bond supply and demand is not balanced. Central banks in major developed economies have amassed close to $10 trillion in government bonds since 2004, and still remain a source of demand of close to $3 trillion more a year. Meanwhile, the net issuance of government bonds of about $2.5 trillion has been on the decline. This demand mismatch is likely one of the reasons there are $4.3 trillion in government bonds outstanding trading at a negative yield. This represents about 7 percent of total outstanding government debt worldwide, estimated by McKinsey to 58 trillion dollars.   

Second, negative yields could potentially be correctly forecasting a sharp economic slowdown, which, as a consequence, could lead to an increase in defaults (both corporate and sovereign) in the future. Paying up now and receiving less nominal money in the future can be profitable if the price of goods has fallen sufficiently.
Third, negative yields could also be a consequence of the ecology of current market participants. Choosing to not own these government bonds as an active allocation decision can (even with good cause due to their negative yields) carry risk for certain investors – e.g., the potential for higher tracking error to their benchmark or underperformance versus their peers. That said, as government bonds have an increased representation in many bond indexes that are used as benchmarks, holding these bonds to stay close to the benchmark also carries a cost: lower absolute returns due to a portfolio with an increasing component of negative return.

Fourth, certain investors who have a preferred investment horizon may require a meaningful risk premium to buy bonds with maturities outside their preferred habitat. For instance, when investors with a shorter horizon are faced with short-term yields in negative territory, the steep slope of the yield curve and longer-maturity bonds might provide the inducement to buy longer bonds. Because they join other investors who invest regularly in longer maturities as part of their own preferred habitat, the ensuing higher demand could be a reason for negative yields on longer-maturity bonds, as was recently the case in Switzerland and Japan.

And lastly, negative interest rates cause currency volatility and capital flight. By adopting a negative rate to weaken the currency, the true goal is to apply a haircut to government debt that is unsustainable as GDP growth stays anemic. The result is negative interest rates lead to one currency appreciate to super strength, namely the US dollar, while the rest of the world currencies depreciate by central banks printing money. The result of negative rates is the opposite from what it was intended; instead of a stimulus, it has led to deleveraging debt. The effect was first through the energy sector by causing distress in high yield markets that has now spread more broadly.       
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Portfolio Strategy
If one believes negative yields are primarily due to demand from passive or indexed investors, then an active investment strategy should tolerate the tracking error and take the other side of the indexing herd. Despite the profit uncertainty of investing in negative yielding bonds, there is a logical approach to constructing robust portfolios. First, control exposure to risk factors where the uncertainty of outcomes may be the most severe, for instance, by adjusting overall portfolio duration. Second, tilt portfolios in directions where relative asset valuation is more attractive, e.g. equity and bonds of companies with solid fundamentals. Third, look for sources of diversification, where the ultimate and eventual resolution of the negative yield conundrum is likely to create large trends and market movements. And finally, in very broad terms, aggressive central bank intervention with negative interest rates continues to underwrite risk taking. At the same, negative rates also cause volatility, currency depreciation and deleveraging of debt. So as more central banks jump on the band wagon to drive rates more negative, an appropriate asset allocation of conservative, higher quality credit risk, floating rate exposure, and maintain high liquidity remains prudent.

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