Negative yields on bonds are back with a vengeance. The five-year German government bond yield reached an all-time low of ‑0.69% after European Central Bank (ECB) President Mario Draghi delivered a dovish speech on June 18, indicating that the ECB could provide additional stimulus if economic downside risks increase and the current inflation outlook remains subdued. This triggered a fall in bond yields globally, with a record of more than US$12 trillion of bonds trading at negative interest rates as of June 19 (see chart). Negative yields mean investors have to pay (rather than being paid) for owning these bonds.
While investors might be satisfied with positive returns from falling yields in the rearview mirror, the picture is quite different when looking ahead. Negative yields represent a significant challenge for investors in traditional benchmark-oriented strategies. The yield on five-year German bonds, for instance, would reduce invested capital by 0.69% each year, or approximately 3.45% over five years. With these negative yields embedded in the respective benchmark-oriented strategies, we believe investors should be exploring alternatives.
Lower compensation per unit of risk
In addition to falling rates, benchmark-oriented investors may be exposed to higher market risk, which is reflected in increased interest rate duration for traditional strategies. Duration measures a bond's price sensitivity to changes in interest rates, and the duration of the Bloomberg Barclays Global Aggregate Index, for example, has increased by 25% since 2010.
A more flexible investment approach may offer value
Allocations to more flexible strategies are one option investors could consider to address the challenges of negative yields. Well-designed flexible bond strategies can help navigate even the most challenging markets by identifying attractive investments from a global opportunity set while seeking to ensure investors receive appropriate compensation for the risk. In the context of negative-yielding assets, this also means steering clear of markets where risks may outweigh future return potential. Compared with traditional benchmark-oriented strategies, which are anchored to an index, the flexibility of a dynamic strategy may allow for a more patient approach and the maintenance of dry powder to deploy during periods of future market volatility and dislocations.
For investors facing the challenges of a low-yield environment, dynamic strategies with attractive risk-adjusted return profiles, flexibility, and low correlations to core bonds and equities may offer a compelling complement to core bond allocations.
Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk and liquidity risk. The value of most bonds and bond strategies is impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Strategy availability may be limited to certain investment vehicles; not all investment vehicles may be available to all investors.
All investments contain risk and may lose value. This material is intended for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. THE NEW NEUTRAL is a trademark of Pacific Investment Management Company LLC in the United States and throughout the world. ©2019, PIMCO
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