With 10-year government bond interest rates stubbornly stuck at near-zero levels in Canada, the U.S. and the U.K. – and below zero in Japan and Switzerland – investors continue to buy. Even bonds with guaranteed negative nominal returns are trading. Some investors prefer small losses in sovereigns to larger losses in stocks. Some worry about China, others about Europe – the list goes on. What’s a financial advisor to do?
One-third of the developed world’s sovereign debt now has negative yields. Driven by the dismal outlook for the slowing global economy, government bonds with miserly or negative returns have become hot investments. Still, paying money for the assurance of less money needs a rationale.
The short-term outlook is for even lower, even more negative rates. The world’s slowing economy means that central banks are not likely to raise rates soon. In mid-March, U.S. investment bank Morgan Stanley Inc. cut its bond yield forecast for 2016 with a prediction that the U.S. Federal Reserve Board will wait until the end of 2016, at the earliest, to raise short rates. The bank also predicted that the U.S. 10-year U.S. Treasury bond’s yield, recently 1.79%, will fall to 1.45% by the end of September. Thus, there is time for bond prices to rise and yields to drop further.
The world lived with negative short-term real bond yields during the workout of the 2008 credit crisis, but negative nominal yields are a relative novelty. Although negative yields frustrate investors who seek nothing more than income and who want to hold bonds to maturity, yields to maturity with minus signs are just a day’s work for traders. After all, if a bond is priced for a minus 0.5% yield to maturity and then new bonds come out with a minus 0.8% yield to maturity, the older bonds’ prices will soar.
Negative nominal rates, which existed in 1932 during the Great Depression, quickly reverted to positive rates within a year. However, in the present debt markets, traders and institutions can live with and even thrive with ultra-low and negative rates. That’s because banks have to hold government debt for regulatory reasons. They just price in low returns, notes fixed-income portfolio manager James Hymas, president of Hymas Investment Management Inc. in Toronto. “It’s market oppression of investors, aided by regulators,” he explains.
Pension fund trustees have no choice but to take what is given. The commuted value of life policies – the capital needed to pay a given pension – soars, pensioners take their reduced payments or pension fund managers hit up their corporate clients for more money to make pension plans whole, and the world moves on.
“We are in a bond bubble that is unprecedented in the history of debt markets,” says Benoît Poliquin, chief investment officer of Ottawa-based Exponent Investment Management Inc. “Bonds are as expensive as they have ever been. But it does not follow that bond prices will rise as yields continue to fall. Since 1871, the average yield on the 10-year U.S. Treasury bond has been 4.64%.” In other words: reversion to the mean has to happen.
Poliquin’s probable scenario: a return to inflation, leading to new bonds that will have healthy and positive rates and the bonds driven to negative yields by high prices will bleed a sea of red ink. That could happen when inflation rises, perhaps preceded by a clear bull market in commodities, he adds.
For now, the bond bubble continues to expand. Fixed-income investors are reaching for yield in treacherous waters. The junk bond market is soaring. So is emerging-market debt.
Ghana, Zambia, Angola and Cameroon have sold sovereign bonds that pay their interest in U.S. dollars (US$). A decade ago, only South Africa had ever sold a U.S. dollar-pay bond to foreign investors. But the new fashion is to borrow in greenbacks, thus relieving investors of having to convert local currency interest payments. For issuing countries, the rationale is that it’s cheaper to pay 10.75% for 15 years in US$, as Ghana has promised to do in a recent issue, rather than pay a return in its currency, the cedi, based on the current 18% inflation rate.
In this odd market, with the choices between sovereign senior nations’ debt that is guaranteed to produce losses and dicey issues of emerging-market debt, investors have been prompted to take modest default risk instead of investment-grade corporate bonds.
“We are at 70% corporate now,” says Chris Kresic, senior partner and head of fixed income at Jarislowsky Fraser Ltd. in Toronto. “That compares with a 28% weight of corporate bonds on the index. I would rather trade default risk for interest rate risk. So, I prefer a five-year corporate to a 30-year government bond.” That play adds 3% to average U.S. Treasury yields.
These days, default is less daunting than what will happen to negative nominal yield government debt when sense returns to the sovereign-debt market. Bubbles burst. That will turn today’s high-priced, negative-yield government bonds into the equivalent of deflated dot-com bubble stocks.
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