Negative yields – how low can they go?

11 October 2019 | Paul Jakubowski

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The concept of negative yields, at least to me, is strange and non-conventional. Paying someone – a corporation or country – to issue debt just doesn't make sense. If you look at the Barclays Bloomberg Global Aggregate Index, the amount of bonds with negative yields has almost tripled in the last three years. In Denmark, a consumer can actually get paid to take a mortgage out, before fees and other charges, as the rate on a 10-year mortgage is -0.5%1!

Now, negative yields don't necessarily mean negative returns. The following three scenarios can cause a negative yielding bond to produce a positive return.

  1. The yield on the bond could go even lower, forcing the bond's price higher and therefore creating value if you sell it at the appropriate time.
  2. "Roll-down" could occur in situations when there is a steep yield curve (as currently exists in the gilt market). This is when a bond's yield falls as it shortens in maturity, pushing the price higher and creating a positive return if sold.
  3. Foreign investors can hedge the currency risk of non-local bonds that have negative yields, in order to earn a positive return. For example, a US investor could buy bonds denominated in euros with negative yields and hedge them back to US dollars, in order to earn a positive return.

So why do negative rates currently exist?

  1. Central banks. Some central banks, including the European Central Bank and the Bank of Japan, have lowered policy rates into negative territory. Why have they done this? To try to stimulate both the economy and inflation. Currently, euro zone GDP and inflation are just 0.2% (QoQ) and 1% (YoY) respectively2. This is far below the desired levels of 3% growth and 2% inflation. The story is similar in Japan. Central banks are trying to encourage consumption and spending by making it undesirable to hold cash, lowering expected returns, and making borrowing extremely attractive. In theory, lower rates should prompt consumers and corporations to spend more money in the form of buying a house, taking a holiday, hiring more workers, or increasing capital expenditures. The downside to this approach is that it also sends a clear signal to the market and consumers that the central banks are worried about the current, and future, state of the economy.
  2. Investors buy government bonds to earn income from what are deemed to be safe assets – bunds, gilts, Treasuries etc. But they also buy government bonds as a safe haven from an economic downturn and subsequent sell-off in risky assets. An investor may assess the current economic and political situation in Europe and Japan, and conclude that they would rather earn a small negative return in bonds versus a potentially larger negative return in equities or corporate bonds if they believe a recession is around the corner.
  3. Investors think rates can go even lower. So far they have been right. Falling yields generate positive returns, but who would have thought we would live in a world where you make money by negative yields going even more negative?

The biggest question continues to be, are negative yields good or bad for the economy and investors? With regards to the economy, it remains to be seen. Personally, I believe negative yields are propping up weak economies on a temporary basis. Without fiscal stimulus or better capital allocation, organic growth will not materialize and investors will be left with overvalued assets that don't reflect fundamental valuations.

Furthermore, the amount of debt outstanding has skyrocketed due to negative yields. If inflation does eventually materialize, and central banks shift policy, the holders of this debt will experience negative returns. The cost of capital for countries and companies will also increase and potentially create a variety of other problems – layoffs, lack of investment and difficulty in servicing debt.

With regards to investors, unfortunately the story isn't much better. Investors expecting to earn a desired rate of return on their savings in order to retire or send their children to university are not going to have the money they need. This could mean people will either have to work more or work for longer. Investors may also be tempted to invest in riskier areas of the market in order to generate a positive return. This is likely to end badly for them when the next recession occurs.

So to answer the original question – how low can yields go? – I believe they can go much lower. However, with every move lower the prospects for future returns and economic growth get dimmer and dimmer.

What does this mean for clients? I'm not going to lie, it's a hard reality. One thing we should continue to encourage them to do is diversify globally. Not all areas of the world have negative yields or less than optimal economic situations. The second thing is not to be tempted to reach for yield or risk. Stick to your long-term plan and maintain your risk appetite. Bonds, even at low interest rates, diversify a balanced portfolio and provide returns that differ from equities.

With contributions from Alexis Gray, Sophie Hunter and John Madziyire

1 Source: Bloomberg
2 Source: Bloomberg

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