Why do people buy negative yielding bonds?

Guest contributor – Craig Moran (Fund Manager, M&G Multi-Asset Team)

The following blog was first posted on M&G’s Multi-Asset Team Blog, www.episodeblog.com. M&G’s Equities Team also regularly post their views at www.equitiesforum.com.

These are extraordinary times in financial markets. On a daily basis we are being bombarded with news headlines of political turmoil, market gyrations, forecasts of the un-knowable, and incomprehensible new technologies.

In amongst all of this chaos – one story that hasn’t attracted enough attention in financial markets was the news last week that the German government issued 10 year government bonds at auction with a negative yield. We also saw the first non-financial company (albeit state owned) issue bonds at a negative yield.

Whilst bond auctions don’t usually grab headlines, this does seem significant and as an event it perfectly encapsulates the risk averse environment that we now live in. While we’ve had bonds trade on the secondary market at negative yields, new issues with a negative yield only serve to emphasise the extreme nature of the current environment.

Bond terminology can be complicated, however to summarise the terms of this auction:

  • Investors pay slightly over 100.5 euros to buy these bonds
  • The bond pays no coupon and produces no income over the entire 10 years
  • In 10 years time, investors receive back 100 euros

Our approach to investing involves seeking to identify and exploit markets behaving in an irrational manner. At first glance the transaction I’ve described above doesn’t seem like a rational one, but it’s important to challenge ourselves as well as the market to identify if we have a quarrel with its behaviour.  So let’s examine the possible reasons why a rational person might engage in a transaction like this.

Rational reasons for buying 10 year government bonds on a negative yield

  1. Sell them to someone else at a higher price

One of the main motivations for buying financial assets is to make a positive return, either in the form of income received, or to sell to someone else at a higher price. In the case of this particular transaction there is no income – so we can rule that out. The possibility of selling the asset to someone else at a higher price (a greater fool) is predicated on hoping that having accepted a guaranteed loss of over 50 cents over the course of 10 years, someone else will be willing to accept an even greater guaranteed loss over a shorter time period at some stage in the next 10 years. It’s betting that bond prices will hit ever higher highs, and yields hit ever lower lows.

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  1. Cash rates are negative

The current ECB Deposit rate is -0.40%, so storing your money overnight with a European bank will cost you an annualised rate of -0.40%. So suddenly the yield on the German government bond at -0.10% annualised doesn’t sound so bad, right? Especially if at some stage that overnight deposit rate might go even lower, although lately it seems policy makers seem to be growing weary of taking cash rates even lower.

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However, even though the bond offers superior yield (less bad at least), in order to guarantee this outperformance you need to hold the bonds for the full 10 years and have cash rates stay where they are now.

Should rates change, or you want access to your cash prior to the 10 year expiry, you are beholden to the market as to what price you will be able to sell your government bond for at the time you want to sell it. The bond has a duration of 10yrs, so should interest rates, or expectations of interest rates move only 1%, we could see a fall of up to 10% in the price of the bond.

Even in the 30 year bond bull market there have been plenty of occasions where transacting at the wrong time would have been an expensive exercise.

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A cash proxy shouldn’t expose you to such timing considerations. Even if institutions are using the Bunds as places to store cash over the very short term, it seems a potentially expensive gamble to take given a modest yield advantage.

  1. Deflation

Conventional economic thinking suggests that money available to spend today is worth more than money available in the future, thus investors should be compensated for deferred consumption. If, however, you are in a regime of falling prices, it may be the case that 100 euros 10 years from now has more purchasing power than 100 euros today.

This is the chart of German  CPI over the past 20 years. Despite multiple economic crises, it has spent very little time below zero (deflation), and averages around 1.4%.

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Even looking from a Europe-wide perspective, the current level of inflation is lower (-0.1% versus +0.3% for Germany), though the long term average is higher at 1.9% (versus 1.4% for Germany).

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Given the history of European inflation, and knowing that policy makers globally are doing everything in their power to avoid deflation (due to over-indebted balance sheets across Europe), a bet that deflation will persist over the next 10 years in order to compensate for negative yields today seems to be a bold one.

Other reasons for buying 10 year government bonds on a negative yield

  1. Regulation

Today’s regulatory environment continues to favour the purchase of government bonds vs other assets, however into the medium term it’s difficult to envision regulators encouraging banks and insurance companies to purchase assets with guaranteed negative returns.  The fact that there’s a non price-sensitive/economically motivated entity temporarily distorting asset prices should always pique the interest of free market participants.

  1. ECB QE

This is a combination of points 1 and 4. Currently there is a non price-sensitive buyer in the market for European Government bonds. Any unencumbered buyer of these bonds in the auction is hoping that the ECB will continue to buy these bonds at ever higher prices disregarding the economic payoffs of doing so.

Or could it be…

  1. “Safety”

One thing that most market participants would agree on is the fact that there is a high probability that you will get your money back if you buy these bunds – albeit slightly less than you initially paid.  It seems today the most likely reason investors are buying this bond (and many, many others at similar yields) is certainty. As we’ve stated before, return of capital has replaced return on capital as investors’ main priority.

This is where our biggest quarrel with the market lies. Safety, or certainty, like everything else – has a price.  A guaranteed negative return on an asset held for 10 years seems like far too high a price to pay today for this perceived safety, especially given where the same ‘safe’ asset has been priced historically, and where it could trade again should risk preference or fundamentals change even modestly.

When it’s difficult to find any rational reason for buying something, should rational investors be thinking about selling it instead?

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

Categorised as: yields

Discuss Article

  1. David Pinheiro says:

    Thanks for the post. Another reason for buying bunds at negative yields is the fact that these bonds can serve as an insurance against a breakup of the Euro Area. In this scenario, german bunds would be converted into deutsche marks and the currency appreciation would compensate the negative yield.

    Posted on: 09/08/16 | 11:09 am
    • Nuno Serafim says:

      Agree. And brexit has underlined even more that risk!

      Posted on: 09/08/16 | 2:52 pm
  2. Anthony Hinds says:

    History is no guide to future performance and after more than $117 Trillion of world wide QE, one might expect some real degree of inflation. Using Japan as the model to extrapolate from, this might suggest that asset prices have to deflate significantly and this happens through debt being transferred from banks and the corporate and private sectors to Government debt. Maybe a study of the worldwide velocity of money would be a better lead indicator of change?

    Posted on: 11/08/16 | 11:35 am
  3. Barry Cowen says:

    The issue is one of ‘deflation’, and so real rates of return. The article looks at historical inflation rates, yet it is expectations of future rates that are important.
    Whilst it is true that ‘policy makers globally are doing everything in their power to avoid deflation’, it is quite possible that they are instead creating future deflation via potentially outdated policies.
    Demographics and government finances mean more of us are having to save for our own retirement. With long term investment returns ever lower (as sought by QE policies) more of us are having to save more (and so spend less) whilst working longer to fund retirement.
    The increased domestic labour supply, from an extension to working lives (that should have happened over the last 30 years – retirement duration has moved from 5 year to 25 years), together with the global labour supply via technological advances and developing markets’ education etc is creating ever greater downward pressure on wages.
    So, lower wage growth, lower long term asset returns, and higher savings needs are impacting the inflation outlook. Previously with wealth levels lower (governments and companies paid for retirement – DB schemes) across greater swathes of society, lowering interest rates boosted consumption and so growth. Now, the balance has potentially tipped, meaning higher rates could boost consumption.
    Yet governments and central banks having encouraged the take up of variable rate debt, especially by the less wealthy, and so are ill positioned to reverse the trend. Raising rates now causes financial pain for vast numbers of the already populist minded electorate – lower house prices, unaffordable debts etc.
    Accordingly policies that are intended to cause inflation look set to continue and to continue to have the opposite to the desired effect.
    So buyers of bunds, gilts et al, are betting that the paradigm persists and that real returns currently available are actually attractive, if negative in absolute terms. Bonds have always been about protecting the real value of money.

    So what needs to change?
    Governments need to encourage the build out of long term fixed rate debt (to protect those with debts) and then to reverse QE. Supply debt to the market, raise long term rates and returns available for savers. Borrow long to finance fiscal expenditure – infrastructure and lower taxes for the poor AND middle classes.
    That in turn will lower the labour supply and the required savings rate. That would encourage spending and wage growth.
    The reality is this is unlikely, at least in the short term. It is a leap too far for central banks, governments, and electorates. It requires a lot of coaxing and leadership, and less wage competition from emerging markets. The former is a forlorn hope, whilst the latter will happen presently. Until it does, lower (even from here) for longer, seems eminently possible, and indeed even likely as current outdated policies persist.

    Posted on: 11/08/16 | 2:15 pm
  4. Joe says:

    For the last point on safety,

    Would holding cash be safer, than negative rates bonds?

    Posted on: 13/08/16 | 12:35 pm

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