No economist forecasted negative yields, nor did fixed income textbooks mention the possibility of negative yields until they appeared in Europe two years ago. Today 40% of the European government bond market is trading with a negative yield and since the CSPP announcement, 10%* of the European corporate bond market guarantees you a loss if you hold it to maturity. The latest trend appears to be the issuance of zero coupon bonds. In March, Sanofi-Aventis pioneered with a 3 year maturity and most recently, the Swiss government issued a 13 year maturity zero coupon bond.
Why do investors buy negative yielding assets? We can make a distinction between the ‘willing’ buyers and the ‘forced’ buyers. The ‘willing’ buyers expect a worsening macro environment, more accommodative Central Bank policy and ultimately, deflation. The ‘forced’ buyers include the banks who need to hold high quality liquid assets for regulatory purposes and, benchmark investors. Indeed, passive and benchmark-oriented investment strategies tend to have high allocations to government bonds (and high quality corporate bonds), which makes them natural buyers of negative yielding bonds. While the overall yield on the index might still be positive, the underlying securities are telling a different story. In traditional benchmarks, such as the Global Aggregate Bond Index, currently over 20% is trading at a negative yield.
Is the US an obvious trade? European and Japanese investors have been hoarding US bonds where overall yields remain attractive on a relative basis. This vast demand in US investment grade corporates has kept spreads tight regardless of the recent record amount of supply which has been partly driven by a pickup in M&A activity. However, investing in high quality US corporates is not a free lunch. Not only has the US started to tighten their monetary policy but the costs of hedging USD assets to EUR are currently at post crisis highs, given the higher interest rate differential and the negative levels within the cross currency basis swap market. Also, the US is further along the credit cycle than Europe with leverage ratios rising, and issuance often used for shareholder friendly activities. These developments reinforce the importance of active management where investments are based on expected performance. This contrasts with benchmarks where underlying securities are primarily based on the issue size. Being able to identify riskier credits early and, as a result avoid blow-ups, is key in today’s low yielding market.
Many investors are worried about their fixed income allocations. If you don’t believe deflation will pose a major risk in the coming years, avoiding negative yielding assets will likely enhance your returns in fixed income. The ability to take a flexible, benchmark-agnostic approach to fixed income has become more valuable today.
*Using mid prices.