Why the Bond Market Is Yielding Negative and What Negative Yields Mean for You

Viewpoint February 2015 Your Global Investment Authority Why the Bond Market Is Yielding Negative and What Negative Yields Mean for You Negative yields on bonds are no longer unicorns. In Switzerland, Germany, Denmark and several other European countries, government bonds are trading at negative nominal yields. There are four potential reasons that can explain the negative yield conundrum and can also illustrate the tradeoffs between different investment strategies. First and foremost, negative yields could simply be a consequence of active monetary policy (with the expressed goal of stimulating economic activity) in a world where bond supply and demand is not balanced. It is certainly possible for negative short term deposit rates in concert with central bank purchases of scarce fixed income assets to drive bond yields negative; policymakers, in fact, hope that this development will drive investors out of safer government bonds into other riskier assets. Central banks in major developed economies have amassed close to $10 trillion in government bonds since 2004, and still remain a source of demand of close to $3 trillion more a year. Meanwhile, the net issuance of government bonds of about $2.5 trillion has been on the decline. This demand mismatch is likely one of the reasons there are $3.6 trillion in bonds outstanding trading at a negative yield (or about 16 percent of the outstanding government bond universe). If this scenario were the sole reason for negative rates, an investor could just take the central banks at their word and move out into the risky asset spectrum since they are, for the time being, underwriting the risk of loss. Second, negative yields could potentially be correctly forecasting a sharp economic slowdown, which, as a consequence, could lead to an increase in defaults (both corporate and sovereign) in the future. Deflation has a similar effect. Paying up now and receiving less nominal money in the future can be

profitable if the price of goods has fallen sufficiently. Note that defaults and deflation usually go hand in hand. In such a scenario, the return of money becomes more important than the return on money. If this is true, then the premium above the face value one pays for a zero coupon cash flow is the insurance premium for a perceived higher likelihood of the return of invested capital. Investors are risk averse in the aftermath of the financial crisis and it is not irrational for them to seek assets they perceive to be highly liquid and safe in an effort to protect themselves against the repeat of losses incurred in the aftermath of the crisis. For example foreign banks have 17 billion Swiss francs in deposits at the Swiss Central Bank at a deposit rate of -0.75%, while yields are as low as -0.15% for a 10-year bond, and this is not likely invested for returns on capital, it is more likely an effort to protect capital and liquidity. If the low or negative yields are signaling a sharp slowdown in the economy to come, then we should ignore the cosmetic levels of yields and buy the government bond market, since yields (and total returns once we capture roll down on the yield curve) are likely to be positive and persistent in this scenario. (To wit, the Japanese government bond market has been one of the best performers on a risk-adjusted basis over the last decade despite persistently low yields, as short-term yields have remained low and the purchase of longer maturity bonds has resulted in investors earning the duration risk premium). Third, negative yields could also be a consequence of the ecology of current market participants. Choosing to not own these government bonds as an active allocation decision can (even with good cause due to their negative yields) carry risk for certain investors e.g., the potential for higher tracking error to their benchmark or underperformance versus their peers. That said, as government bonds have an increased representation in many bond indexes that are used as benchmarks, holding these bonds to stay close to the benchmark also carries a cost: lower absolute returns due to a portfolio with an increasing component of negative return. And this cycle reinforces itself: As continued investor demand meets fewer new bonds available to match indexes, investors may have to accept this cost in order to manage risk versus their benchmarks. Figure 1 demonstrates this in terms of the percentage of the indexes in market value terms trading at negative yields. Since the middle of last year the percentage of government bonds in the JP Morgan Global Government Bond Index has risen to as high as 40% for Switzerland and Denmark, and about 20% for Europe. Fourth, certain investors who have a preferred investment horizon may require a meaningful risk premium to buy bonds with maturities outside their preferred habitat. For instance, when investors with a shorter horizon are faced with shortterm yields in negative territory, the steep slope of the yield curve and longer- FEBRUARY 2015 VIEWPOINT 2

maturity bonds might provide the inducement to buy longer bonds. Because they join other investors who invest regularly in longer maturities as part of their own preferred habitat, the ensuing higher demand could be a reason for negative yields on longer-maturity bonds, as was recently the case in Switzerland. If one believes negative yields are primarily due to demand from passive or indexed investors, then an active investment strategy should tolerate the tracking error and take the other side of the indexing herd. Alternatively, for an active investor, buying at a negative yield with guaranteed loss if held to maturity can still be a profitable strategy if the security is not held to maturity (i.e. if one is willing and able to patiently wait for the opportunity to find another greater fool to buy at still a higher price and a more negative yield). Recently, yield curves in Switzerland and Germany have become somewhat less negative, while yield curves in Denmark and Sweden more negative. These changes speak to a market attempting to find equilibrium by quickly shifting duration positioning in portfolios. FIGURE 1: THE PERCENTAGE OF MANY GOVERNMENTS SECURITIES IN THE J.P. MORGAN GLOBAL GOVERNMENT INDEX TRADING AT A NEGATIVE YIELD HAS JUMPED % of Global Govt Index at negative yield 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% 27-Jan-14 27-May-14 27-Sep-14 27-Jan-15 CHF EUR SEK DKK JPY Source: J.P. Morgan index data, daily January 2014-present At any rate, the result so far of all this has been that the duration-weighted yield i.e., the yield that would result from buying a country s entire curve of major developed countries is converging to rates in Japan, which has had persistently low yields for over two decades, and not the other way around. FEBRUARY 2015 VIEWPOINT 3

FIGURE 2: DURATION-WEIGHTED YIELDS OF SELECTED COUNTRIES Index Duration weighted yield (%) 8 7 6 5 4 3 2 1 0 France Germany Japan Netherlands Australia UK US Source: J.P. Morgan Global Government Index data, monthly 1999-present. Duration-weighted Index yield = yield duration of individual security/total duration of the index. As investors, our response to the negative yield conundrum may depend in part on which one of these four explanations is the most important. And since the examples above are not necessarily mutually exclusive, and are, in fact, interrelated, the simple and straightforward solution we would always like to find, as usual, remains elusive. For now, investors should pay close attention to the signals from policy makers, economic data, and anecdotes from other participants to create a flexible framework for investing in a world of negative yields. Despite the uncertainty, there is a logical approach to constructing robust portfolios. First, control exposure to risk factors where the uncertainty of outcomes may be the most severe, for instance, by adjusting overall portfolio duration. Second, tilt portfolios in directions where relative asset valuation is more attractive, e.g. equity and bonds of companies with solid fundamentals. Third, look for cheap sources of convexity and diversification, where the ultimate and eventual resolution of the negative yield conundrum is likely to create large trends and market movements. And finally, in very broad terms, aggressive central bank intervention with negative interest rates continues to underwrite risk taking. So if/as rates go more negative, an asset allocation of long equity risk versus underweight core government bond duration remains attractive. FEBRUARY 2015 VIEWPOINT 4

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