The explosion of bonds with negative interest rates continues, driving some investors to take on more risk and some simply to despair.
Lending money at negative interest rates is in some ways the worst of both worlds: you part company with your funds, losing their use and paying for the privilege.
Yet a combination of weak growth, very low inflation and fear over the upcoming UK EU vote have driven a renewed plunge in bond yields, with 10-year yields touching one-year lows across most of Europe on Thursday. German 10-year yields are now just 3bp above zero, and Swiss 30-year yields are only 7bp higher.
More than US$10trn of sovereign debt was trading at negative yields at the end of May, according to Fitch data, 5% more than the month before and likely lower than as of today. Something like 15% of all investment-grade eurozone corporate debt is negative yielding, helped along by the European Central Bank’s campaign to stoke inflation and growth by buying company debt.
All this has driven a move into riskier debt, as shown by a one-third reduction since February in the extra spread investors get above Treasuries to hold US junk debt, now at about 580bp. One-hundred-year bonds are selling well and even Illinois, which has been without a budget for 11 months, is only seeing 10-year bond yields of a bit less than 3.5%.
Little wonder some bond investors sound apocalyptic.
“Global yields lowest in 500 years of recorded history,” bond king Bill Gross, of Janus Capital, said on Twitter on Thursday.
“This is a supernova that will explode one day.”
While the market can stay crazy longer than you, me or Bill Gross can stay solvent, his larger point, that the good old days of bond investing are gone, is well made.
Gross points out, in a recent letter to investors, that for most living investors, their experience of buying bonds has been a happy one, with steady returns, little volatility and only seldom a down year. Starting from here, with global yields so low, that experience should not be taken as a guide.
“The bond market’s 7.5 percent 40-year historical return is just that – history,” Gross wrote.
“In order to duplicate that number, yields would have to drop to -17 percent! Tickets to Mars, anyone?”
Meanwhile back on earth
Meanwhile back on Earth, the forces that made all of this possible are generally under threat. Rates probably cannot go too far lower, globalization is, if not in retreat, under serious threat and debt is ever less effective at creating economic growth.
The ECB waded into eurozone corporate bond markets again on Thursday, a day after it made its first purchases of what sources have told Reuters will be a €5bn to €10bn per month campaign. Given that net new issuance of corporate bonds in the eurozone may only total €100bn in 2016, it is fair to expect yields to drift lower.
This is of course intended to push investors, not to despair, but to lending money cheaply elsewhere, perhaps by buying bank bonds, which are not eligible for ECB purchase. It may help to spur growth, but it may also simply lead to poor capital allocation as investors take chances to make their return targets. Short-term rewards in fighting deflation may have long-term costs. Mal-investment, unlike market prices, takes a long time to reverse.
The poor alternatives are driving banks and brokers at the center of operations to consider taking radical steps, though perhaps mostly in protest at a negative interest rate policy which hurts their prospects.
Commerzbank, part owned by the German government, is considering simply warehousing billions of euros in its vaults rather than paying to park the money with the ECB, sources told Reuters on Wednesday. This may be grandstanding, but it certainly does not indicate that falling corporate or bank bond yields will somehow light the fuse of loan demand.
Bank of Tokyo Mitsubishi UFJ said on Wednesday it was considering giving up its status as a primary dealer of Japanese government bonds, a previously sought-after role which placed it at the center of both trading and information in one of the world’s most important government bond markets. With the Bank of Japan dominating the market as it buys up debt as part of its QE program, and with much of the Japanese yield curve trading at negative yields, primary dealers face growing risk and little reward.
Growing risk and little reward – that pretty much sums up bonds.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
