Why are investors paying to lend to governments?

Tue 27 Aug 2019

It seems we should all be taking on debt. After all, about 30% of the global tradeable universe of bonds is negatively yielding, amounting to around $16.7trn. With bonds that are negatively yielding, holding to maturity guarantees a loss, at least in nominal terms. In other words, it seems you are being paid to borrow.

In reality it is capital appreciation of existing debt, generally issued at a positive yield, which is causing negative yields. Even Germany, where yields are in negative territory for all maturities, hasn’t issued debt at a negative yield, instead planning a 30-year bond with no coupon. That said, Danish banks have been offering negative interest rates on mortgages since 2015 and have started charging interest on customer deposits, while Swiss bank UBS is also planning to charge for holding deposits.

So why, if you are paying for the pleasure of holding bonds, are they worth holding in a balanced portfolio? After all the steady coupons received are supposed to accumulate over time to offer a steady return, while holding equities is where capital gains are usually made. Well there are two main reasons which remain valid, although do not necessarily override the issues caused by negative yields.

Firstly, we are used to the idea of inflation being positive, i.e. things getting more expensive over time. If this is the case, aside from compensating for the risk of not having the money returned at maturity (the counterparty risk), bonds need a positive yield to compensate for the fact that in real terms, the money paid back at maturity will be worth less than at the time it was lent. However, with economic growth anaemic since the Global Financial Crisis, and concerns about a coming recession, inflation and expectations for future inflation are very low, and in some cases negative. If inflation does turn out to be negative over the course of a bond’s lifespan, the money returned is actually higher in real terms. In this case, setting aside the counterparty risk, a negative interest rate is not so preposterous.

The second reason is that even with yields extremely low, government bonds in particular continue to have a low, sometimes negative correlation with equities. Government bonds continue to be used as a ‘safe haven’ asset, generally performing well in times of negative sentiment as prices rise due to increased demand. Conversely poor economic sentiment tends to be (although isn’t always) negative for equity returns.

For example, last October concerns began to rise about the state of the global economy. At this time German 10Y Bunds were yielding only 0.573%, hardly attractive by historical standards. Going back 20 years, the assumption would likely have been that the yield could not fall below 0%, limiting the downside protection available from owning such an instrument. However yields have fallen to -0.647%. The price return has been 12.7%, even without the coupon, which is an unimpressive 0.25%. Meanwhile over this time global equities are slightly down, having fallen significantly towards the end of 2018 before recovering this year. Since the yield went negative in May, the 10Y Bund has returned 6.2% in capital gains. In the right conditions, there are clearly gains to be made on negatively yielding bonds.

One of the quirks of the mathematics behind bond pricing means that the lower the coupon on a bond, the greater capital appreciation it will experience from a given fall in yields. So recent low coupons will inadvertently offer greater downside protection for portfolios if yields can continue to fall when equities do.

However the level of expensiveness does create issues. The first being that the previously mentioned low coupons mean a given rise in yields will incur a greater capital loss. In effect bond prices are likely to be more volatile, perhaps increasing the level of risk in a portfolio rather than dampening it.

Further, given that yields are at historic lows, can they go any lower? Or are they destined to rise, especially if there is a bout of global inflation?

We have an underweight to bonds in our portfolios due to how expensive the asset class is as a whole and the risks described above. Yet, despite it seeming intuitively wrong, there has been no evidence that bond yields can’t reach new lows and continue to offer a diversifying return, especially in periods of market stress.