Stand aside – this bond bubble will blow

Investors are paying governments for the privilege of lending them money. That may make sense to some – but we won’t be following them, says John Stepek.

This week, Germany made financial history. It sold a five-year government bond (bund) at a negative yield for the first time. It's not the first country to do so Finland had already achieved this particular feat but as the Financial Times points out, the market for German bunds is one of the biggest sovereign bond markets in the world.

Investors who bid for these at auction are paying the German government 0.08% a year for the privilege of lending to it. If held to maturity in 2020, these bonds will pay back less than was borrowed.

This is not an isolated incident. German five-year debt has been trading in the open market at negative yields for most of 2015 (see chart below this is just the first auction that saw investors buy at a negative yield). As the FT points out, Finnish, Dutch, Austrian, Danish and Swiss five-year bonds all have negative yields now.

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Even Ireland once lumped in with Greece as one of Europe's big problem areas can now borrow over ten years for less than 1%. Earlier this month, JP Morgan reported that around 16% of all government bonds issued had negative yields. So why would anyone buy into what looks like a sure-fire losing bet?

Bonds: a quest for a safe haven

It may look mad, but there are several reasons why an investor might want to buy a bond with a negative yield today. Firstly, if you're looking for "safety", you might well be happy to put money into bonds from a reliable developed country.

If you buy the bond and hold it until maturity, you can be almost certain that you'll get paid your coupons (the annual interest payout) and you'll also be repaid on maturity. So you know exactly what you're going to get (in nominal terms).

The biggest risk you run is not credit risk, but rather that inflation will take off, and the money you get back over time will be worth a lot less in "real" terms than when you bought the bond.

But if inflation doesn't seem like a problem (and right now, it's low in most countries and negative in Germany), this might not worry you. So while the upside may look limited, so does the downside and if you need somewhere relatively safe to put a large amount of money, a bond offering a reasonably predictable level of mild downside could be acceptable.

And if deflation does take hold, you might still find that, although you lose out in nominal terms, you could still profit in real terms if you buy a bond with a negative yield of 0.5%, but prices in the wider economy fall at an average annual rate of 1%, you end up ahead by 0.5% a year, in real terms. So both fear of deflation, and a willingness to pay up for a "safe" investment, help drive the rush to bonds.

Great fools line up

On the more speculative side, investing in bonds from overseas governments is a way to bet on currency movements. A Swiss government bond might look like a poor investment if you live in Switzerland. But if you would like to own Swiss franc assets because you think the franc will keep rising against the euroor the dollar or the pound, then buying Swiss government bonds offers a way to bet on this.

It may be hard to make this argument for German bonds the euro is not a strong currency right now but that's assuming that you believe German bonds will be paid back in euros. As my colleague Bengt Saelensminde has speculated, the eurozone end game might involve Germany leaving the euro.

Owning German assets (which would potentially be redenominated into a much stronger currency) would likely be very attractive in that instance.

Then, of course, there's "greater fool" theory. Bonds tend to be quoted in terms of their yields (unlike shares, where we focus on prices). So it's easy to forget that they're just like any other asset you don't have to hold them to maturity, you can make money simply from the price going up, as long as you can find another buyer who'll pay you more for it.

In 1999, people were happy to pay ludicrous sums for stocks that paid no dividends and had no sales or profits because they reckoned someone else would always be around to pay an even more ludicrous sum. Similarly, you might be happy to buy a bond with a negative yield of 0.05%, as long as you think you'll be able to sell it in the near future at a higher price, on a yield of -0.2%, say.

This is risky, sure, and it's bubble thinking. People never appreciate the risks during bubbles they only see the upside. But there are a lot of potential "greater fools" out there.

In Europe, Mario Draghi and the European Central Bank (ECB) are about to print a load of money to buy bonds from whoever's selling them, at whatever price they have to. Passive funds tracking bond indices also buy negative-yielding bonds without question.

What Buffett is buying

So you can see that there are many reasons why investors might be willing to invest in bonds with negative yields. But that doesn't mean it's a good idea. For one thing, it's never sensible to buy an investment purely on the basis that you hope someone else will buy it from you at a higher price.

"Buy high, sell higher" can work during a bubble, but it's also a good way to get wiped out when the crash finally comes and timing your exit is never easy.

The other main reason to buy fear of deflation may seem more sensible. But bonds are now pricing in rather a lot of deflation. There's a lot of talk of "secular stagnation" and robots stealing our jobs and demographics being hostile to investors. But what if these particular disaster scenarios don't pan out the way people expect?

Germany might be in the throes of deflation for now, for example. But Germany's largest union IG Metall has just agreed a pay rise for staff in one of Germany's richest states, of 3.4% from April. Meanwhile, unemployment throughout the rest of the country is at its lowest level 6.5% since reunification back in 1990. Rising employment puts more pressure on wages to rise (as companies compete for labour).

Higher wages should boost spending and, ultimately, prices. Consumer confidence is buoyant too. As one Goldman Sachs economist told the FT: "Signs that German wages will rise by between 3% and 4% this year is not an immediate solution to getting eurozone inflation back to the ECB's target of 2%. But it will help."

Germany is not the only economy in this position. Employment is high and wages gently ticking higher in Britain, Japan and America (where staff competition has just forced giant retailer Walmart to lift its minimum wage levels).

We're not saying a deflationary scare, or crash landing, isn't possible. But the risk/reward pay-off in bonds looks hopelessly skewed to one outcome in short, it looks like a bubble.

This week, around about the same time as those five-year bunds were being auctioned off, American investor Warren Buffett revealed that he planned to buy more companies in Germany, having just bought a German biker accessories chain.

As Buffett put it to Reuters: "The bottom line is that the weak euro is naturally good for acquisitions. But the euro's exchange rate is not our primary motivation. We simply want to own more good companies in Germany that's our goal." We'd certainly be more keen on buying German stocks (and those of other eurozone stockmarkets) than on buying bunds.

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.