Why would you pay anyone for the privilege of lending them money?
In the latest in his series on fixed income investing, David Stevenson explains what’s driving the trend towards negative-yielding government bonds – on which you are guaranteed to lose money.
The world of gilts, otherwise known as UK government securities, is seen as exceedingly boring.
That's as it should be. This is developed world government debt we’re talking about. The whole point is that it’s the absolute opposite of exciting – it’s stolid and extremely low risk.
But in May this year, something truly extraordinary happened. Something which shook the UK bond investment community to its core.
The astonishing rise of negative-yielding bonds
In an auction in mid-May, the British government’s Debt Management Office sold £3.8bn-worth of three-year gilts at a yield of negative 0.003%.
The jargon used here can sometimes sound a bit confusing. But the bottom line is extraordinary – if a bond has a negative yield, as this one did, it means that the British government is effectively being paid to borrow. Initial investors in that bond would get back slightly less than they paid, assuming they hold the bond to maturity in three years’ time.
The casual observer might be forgiven for thinking that this was an oddity, generated by cautious investors reacting to the Covid scare and thus simply desperate to find a safe haven for their cash.
That rationale certainly explains one reason why you might buy a bond on which you are guaranteed to lose money – that you’re so desperate to put it somewhere “safe” that you’ll pay a government with a good credit rating to look after it.
But this gilt sale was no exception. As interest rates around the world have fallen, the total value of bonds with negative yields has surpassed $15.6trn. That’s something like 28% of the Bloomberg Barclays Global Aggregate Universe.
That’s still “short of a $17trn peak [seen] last year”, according to a Bloomberg report from the summer of 2020. And yet it goes to show the scale of the phenomenon, which is extremely unusual, to say the least.
What’s driving this trend towards negative bond yields?
Europe is at the centre of this peculiar trend. Interest rates on German government bonds (Bunds) have been in negative territory for months now. But even some of Italy’s government bonds – regarded as far riskier than Germany’s – have been trading at negative yields. Even some corporate bonds now have negative yields.
And note that, while the pandemic triggered another slide in yields as investors rushed to the relative safety of bonds, the rising volume of negative-yielding bonds far predates the Covid-19 outbreak. Indeed, by mid-2016, around 60% of eurozone government bonds already had a negative yield.
So there are obviously longer-term structural forces at work driving this trend.
There has certainly been a very long-term trend for interest rates to fall over time, and the difficulty that both governments and central banks have faced in keeping economic growth going, and challenging deflation since the financial crisis of 2008, has played a role.
That said, it's not easy to separate this long-term trend from the radical action taken by central banks in the last decade. Quantitative easing (QE – where central banks “print” money to buy assets) has certainly played an important role, by driving up demand for bonds from central banks, eager to buy assets for their balance sheet.
The European Central Bank’s pandemic programme totals €1.35trn, while the Federal Reserve is buying about $80bn of bonds a month. Also, several G10 economies have cut policy rates to below zero – in other words, central banks have set short-term rates negative. Recently there has been talk of the Bank of England doing likewise.
Bonds that cost governments absolutely nothing – indeed, that they get paid to issue – sound like an amazing gift, and many have urged governments to take advantage. But there are very real potential risks.
Negative interest rates, for example, erode the profitability of banks, which risks in turn reducing the availability of credit in the economy at a time when banks’ resilience is much needed. Banks have sought to offset negative rates by charging higher fees, repricing mortgage spreads and, in some cases, lending more aggressively (and thus exposing themselves to higher bad debt risk).
Negative bonds might also prove a long-term threat to the solvency of insurers and pension funds – these cautious institutions need a positive return in order to be able to fund their long-term policy commitments, usually by investing in a combination of “safe” gilts and less safe corporate bonds. If both are negative yielding, they might be tempted to take undue risk to goose up returns for policyholders.
What’s indisputably true is that if the sheer quantity of negative-yielding bonds keeps increasing and then stays at these yields, we are all collectively storing up trouble for the future – which is, ironically enough, one reason why central banks are printing money and slashing rates so frantically in the first place.
One last key point: bond investors and bond fund managers are not necessarily doomed in a negative-yield environment. For starters, investors can make money by buying positive-yielding bonds which subsequently turn negative, or even by buying bonds which are already negative yielding, but then experience even sharper declines in the negative yield.
The point is that bond prices move up and down in value, so it’s not just about the income – there are the potential capital gains to be made should rates turn even more negative.
Also, there are still plenty of bonds paying positive yields, thus providing investors with some income – US Treasury bonds, for instance, still offer positive yields across the board, as do most corporate and emerging-market bonds. We'll take a closer look at emerging-market bonds in our next email in this series, next week.