Negative yields: Sense or nonsense?

The second group are the investors who see the world economy as being wobbly. For them, a negative-pay bond today may be a speculative wonder if the global economy worsens and today’s negative-pay bonds are surpassed by others issued tomorrow at even lower coupon rates.

Third are portfolio managers at insurance companies and pension funds for whom a bond that loses a little money is just a regulatory requirement whose cost will be priced into their products.

The gloom that seems intrinsic in a bond that will be worth less when it matures than when it was issued turns out to be more worry than fact. That’s partly because there still is a hefty margin between the rates that banks lend at, which is never negative, and what they receive on their capital. If a bank’s capital has a small nominal cost rather than a positive return, the bank simply adds that cost into the price of its loans. On long-term loans like mortgages, a bit of negative-pay capital is just a regulatory cost – and hardly the largest. As Edward Jong, vice president and head of fixed-income at TriDelta Investment Counsel Inc. in Toronto, explains: “If you look at the balance sheet rather than the income statements, appreciated negative-pay bonds are in the black.”

The true cost of nominal negative-pay bonds remains the price risk that a buyer accepts when buying any bond, whether it is to be traded soon or held to maturity. A 60-basis-point move in a month is hardly unusual. Negative-pay bonds have no yield to cushion losses, but any long-duration bond is much the same. If interest rates rise or are thought to be about to rise, the holder of bonds will have a loss (on paper).

That a bond has a negative nominal return if held to maturity is not important for those investors who don’t plan to hold that bond for very long.

“Bonds with negative nominal yields are not so different from those with positive yields,” says Jack Ablin, executive vice president and chief investment officer of Chicago-based BMO Harris Bank NA, which operates as BMO Private Bank. “For traders, it is price risk, much more than yield, that matters.”

For a negative-pay bond investor, whether a nimble retail account or an institutional trading desk, swapping out a negative-pay bond for a floating-rate bond is possible. The cost could be negligible, but the risk is clearly less if a floater just goes with the interest rate trend.

For longer-term investors, holding long negative-pay bonds is not daft in macroeconomic terms because interest is both the auction price of money and a reflection of expected inflation. In a stagnant world economy, the demand for money will tend to be moderated by reduced prospects for economic growth.

“There is not much reason to believe that inflation will suddenly break out and drive up interest rates,” notes Chris Kresic, senior partner and head of fixed-income at Jarislowsky Fraser Ltd. in Toronto. “Central banks are still printing money, so interest rates will tend to stay low.”

Low and negative interest rates, therefore, do not change the rules of the bond game. The most that happens is that bets change. As interest rates decline and become even more negative, duration rises. Negative-pay bonds are riskier; but, on the other hand, if interest rates decline further, the existing negative-pay bonds still will generate speculative gains.

Negative-pay bonds hurt the most in portfolio management. The usual advice to hold some bonds in a portfolio to offset equities’ risk still is valid. But with no interest yield to cushion a price decline in a negative-pay bond, price risk is magnified. If stocks tumble, bond prices should rise.

But central banks that use quantitative easing cancel bond price rises. As of the end of June, stock prices roller-coastered down and then up while bond markets, sustained by central banks, did not rise when stocks fell nor did bonds fall when stocks recovered. The problem is the absence of the usual linkage between bonds and stocks.

Negative interest rates are separating institutional investors (for whom falling rates are a mixed blessing) and private investors (who face high duration risk and intrinsically low returns). The usual trading mentality – buy low and sell high – applies to bonds priced to guarantee losses if held to maturity. If inflation should rise or central banks decrease their bond purchases, the losses to government bonds will be stupendous.

It is not clear if stocks are insurance for overpriced bonds or bonds are insurance for stocks that are not yet comparably overpriced. Negative-pay bonds are costly stock insurance. Without an interest cushion, risks rise.

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