Negative Yields And Asset Allocation

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Includes: BNDX, BWX, EU, IGOV
by: Evariste Lefeuvre

Summary

A growing share of sovereign bonds (in Europe mostly) have negative yields.

This has several implications on the risk profile of so-called "risk free" assets.

I show here that risk is now skewed on the negative side, which means that the risk profile of many default-free government bonds is getting close to that of stocks and corporate bonds. This has several implications for strategic asset allocation.

Very low, or even negative, yields raise an additional risk for asset allocation: that the risk-profile of risk-free assets, i.e., government bonds, will change and entail a revision of portfolios' benchmarks.

This risk is clear to see in the ECB's case. The ECB buys bonds well above their par value. If the ECB pays an additional 20% of the nominal value to buy sovereign bonds, it runs the risk of generating a net loss when the bonds are reimbursed at par at maturity (buy & hold). This loss explains why certain countries are against the monetary financing of public deficits created by the QE since this results in a capital loss that some consider a threat to the institution's stability.

Long-term private investors need to consider this risk of a capital loss seriously. In general, negative interest rates make the yield profile - and therefore the risk profile - of bonds increasingly asymmetric. Even though, unlike interest rates, yields are able to fall below 0%, their downside is nevertheless limited (particularly in the case of the QE implemented by the ECB, which refuses to invert tremendously the yield curve and thus buy sovereign bonds offering yields below the deposit rate of -0.2%).

The return expected from a 10Y bond can simply be described as the sum of the current yield and its expected variation multiplied by its duration:

E(Return) =Y10- DurationxΔ(10) (current 10-year yield minus the product of duration times the expected change in 10-year yield)

If Y10 negative and its downside potential Δ(10) limited, there is a risk that the expected return will be very low. The fact that a risk-free asset's (expected) return is low is not a problem in itself. But it still needs to offer the statistical characteristics required of a "risk-free asset." Risk-free assets generally have a "positively" skewed distribution. This is referred to as a positive skew, i.e., yields are generally mostly concentrated around the average, and extremes tend to be positive. When the skew is negative - equities, corporate bonds, forex - the extreme risk characterized by the skew is negative (the tail of the distribution is much fatter on the left than a simple "normal" distribution would suggest). It is this statistical characteristic, among others, that justifies holding bonds in investment portfolios.

The table below covers the period 1999/2015 with two sub-periods: 1999/11 and 2012/2015. It shows the skewness/asymmetry of monthly returns of government bonds of several tenors (2/5 and 10 years). If returns were following a Normal distribution law, they would show no skewness (skew ≈ 0).

The outburst of the sovereign crisis changed the nature of the distribution of return of several peripheral countries. As can be seen above, the credit/default risk associated with non-core countries was clearly demonstrated by the presence of a negative skew for Italy, Greece and Portugal. France and Germany, on the other hand, show a slightly positive skew. This has changed recently as the 2011/2015 sample shows. This clearly highlight the changing nature of risk of many - and even not default-prone issuers - sovereign bonds. This statistical bias (negative skew) could remain for a while for at least two reasons.

The first, already mentioned above, is linked to the limit-down explicitly set by the ECB (a yield threshold of -0.2% below which the ECB will no longer buy bonds). With the downside potential for yield is limited, the expected return on bonds is clearly skewed.

The second is linked to an empirical observation: the more illiquid a sovereign bond market, the greater the risk of negative skewness. If the ECB becomes a major operator on the market, there is a greater risk of liquidity drying up.

Massive bond purchases by the ECB, combined with limits on the downside potential of sovereign yields (-0.2%), could change the statistical distribution of core sovereign bond returns and thus thoroughly modify the logic behind asset allocation strategies. By losing their normality, not for credit risk reasons but because of factors linked to the ECB's policy and the risk of illiquidity, core sovereign bonds would become more "normal" assets, which means that benchmarks based on such risk-free assets would have to be overhauled.

So the consequences of negative yields need to be examined from at least two perspectives:

- The first concerns the underlying reasons for the phenomenon and the way in which each factor responsible for the drop in interest rates (inflation expectations, monetary policy, growth prospects) is interpreted (see my post here).

- The second concerns asset allocation and investor rationality.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.