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Negative Yields – What They Mean And Where They Are Headed

Negative sovereign bond yields have become the norm in Europe now. For a number of countries, including Switzerland, Germany, & the Netherlands, the 5 year bond yields are already in negative territory. Last month, Switzerland became the first country in history to auction 10 year bonds at negative yields. Belgium recently auctioned 5 year bonds at negative yields & became the sixth country - joining Germany, the Netherlands, France, Austria & Finland - to auction 5 year bonds at negative yields. The 5 year notes in Belgium were sold at an average yield of -0.056%. The 10 year German Bund is currently yielding 0.097% (has recently spiked to ~0.285%) & it should not be long before they move into negative territory. According to a latest report by Goldman Sachs, yields on close to $2 trillion of outstanding sovereign bonds in Europe are in negative territory. Another brokerage house J.P. Morgan, predicts that bond demand will likely outstrip global supply by $450bn this year as investors continue to hunt for yields. A table below sheds some light on the sovereign yields of various countries across the maturity spectrum.

Primary/Fundamental Reason for Negative Yields

The primary reason for negative yields in the countries mentioned above is the launch of the bond buying (QE) program by the ECB chair Mario Draghi. Under this plan, the ECB plans to purchase more than €1tn in assets, including government & private sector bonds by September next year (This plan faced a staunch opposition from Germany initially but on March 9th, the ECB said that it would start its bond buying programme including some private sector assets). The plan was to suppress the borrowing costs for most of the Euro-Zone countries so that the business investment climate & private consumption could be increased to foster economic growth and get the Euro Zone out of deflation.

Now we come to the important part on whether these negative bond yields are justified and why are investors paying someone to lend money? If the negative underlying bond yields are helping to kick start investments in major European countries, then the answer to the first part of the question is a very simple yes. How long will the yields stay negative is anybody's guess, but fundamentally the yields should start moving up once the ECB ends its QE Program. In hindsight, if we compared 10-year bond yields of some of the GIIPS (Greece, Ireland, Italy, Portugal & Spain) countries with the U.S. (also highly rated by the rating agencies), such low bond yields do not justify fundamentals. 10 year Treasuries yield around 1.9% currently where as countries like Italy and Spain have 10 year yields trading at ~1.4%. Why would countries which have exorbitant debt to GDP ratios (Italy has a Debt to GDP ratio of ~132% & Spain has a Debt to GDP ratio of ~98%) & weak macroeconomic fundamentals compared to a big economy like the U.S. have less borrowing costs? We believe that the fundamental answer to the same lies in the fact that the borrowing costs for these countries have been suppressed by a shortage of safe assets and hunt for yields, and more recently, by the ECB's bond buying programme. Banks & financial institutions who already hold these bonds do not want to part with the same for other speculative assets. So currently there is limited supply in the markets with a lot of demand from the investors & the ECB which is driving down the yields for countries like Germany, Spain and Italy lower.

Coming to the second part of our question on why would someone buy a bond with negative yield we present some scenarios below:

  • Insurance companies & pension funds have a mandate to invest a part of their corpus in safe assets regardless of their yields. They have to invest in bonds with a definitive rating mandate.
  • Risk-averse investors might accept a negative bond yield as an insurance premium to keep their money in a relatively liquid debt instrument, as opposed to in a bank in a vulnerable Euro zone country like Greece. Such an insurance premium would protect their money from being "bailed-in" in case the bank goes bust.
  • Thirdly, investment in negative bond yields can be a pure trading play in the sense that investors/traders expect the yields to fall further and hope to sell it at a capital gain later to someone else. Also, the investor might be speculating that the currency in which the bond is denominated will rise in the future. This issue was recently seen with Swiss government bonds. The Swiss government decided to drop its peg to the EURO which led to the Swiss Franc skyrocketing by some 30%, making some capital gains for the holders of those bonds.

The negative sovereign bond yields are having a spillover effect as other Euro zone countries are also expected to move into the negative bond yields territory. The spillover effect is also seen on the bonds of some of the major companies like Nestle (EUR bonds maturing in 2016 traded at negative yields during February & are trading slightly positive now. The 2018 CHF bonds are currently yielding negative) & BP (Some CHF bonds due around 2015-2018 are yielding negative).

The Road Ahead for Negative Yields

Finally we would like to highlight the broad point of where we are headed with such low yields. One would expect the sovereign yields to rise once the ECB starts hinting at ending its QE program which should not be before September 2016, unless inflation expectations in the Euro zone were to rebound dramatically. The 10 ten year Treasuries traded for a large part around 1% when the Fed's QE program was in place. On a hint of tapering by the Fed, the yields had spiked to ~3% initially but have settled at around 2.02% recently as the timing for rate hike keeps getting pushed back.

Some people have talked about a bubble being created in not only the bond markets but also broader financial markets because of the prevailing low borrowing costs. There are schools of thought that have also highlighted the fact that the ultra cheap yields have led people to borrow money and speculate with it in the financial markets rather than this money benefiting the underlying economy. However, we can put this case to rest owing to the fact that both corporate and sovereign defaults have been very low in recent times and the success of low yields and borrowing costs can be gauged by the steadily improving U.S. macroeconomic indicators. The sovereigns of many of the Euro zone economies might enter into negative territories & for the ones already in the negative territory the yields can fall further. It is upon the investor to decide whether or not he wants to invest in sovereign bonds with negative or ultra low yields, hoping to keep his money in a relatively safe haven asset & book profits if someone else is willing to pay a higher price for the same instrument later.

Investors who have already piled onto sovereign debt of the economies mentioned above have made a lot of money. Bonds in general, both sovereign & private, was one of the best performing asset classes of last year. The future, however, may turn out to be very differently from the past. Recently "Bond King" Bill Gross has said that the 10 year German Bunds "Represent a lifetime Opportunity", and has asked people to short it if yields move into negative territory. Some institutions like the "Bank of International Settlement", have warned that negative bond yields could have damaging consequences. It suggested that people could end up working longer to make up for shortfalls in their pensions. Only time will tell what the future has in store.

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

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