Should the negative yields silence the bond bulls?

Good morning!

Yesterday was a strong day for European government bonds as the approach of the European Central Bank bond buying programme (better known as QE) nudged investors to overlook the low yields on offer. The price gains were so strong that the yield on the 7 year German government note is now in negative territory as are the 10 year Swiss bond yields.

First, I would briefly discuss why would one invest in an asset with negative yield as did is a question we often encounter.

One factor is the negative deposit rates introduced by ECB and, more recently, Denmark, Switzerland and Sweden. As the larger investors cannot afford moving into physical cash (which in any case would imply transaction and storage costs), government bonds become an alternative.

Even when bank deposit rates are above 0%, the non-retail investors with sizable cash holdings might refrain from putting all their cash into deposits because the balances are generally guaranteed only to a small degree, if at all.

Although this is sort of a chicken and egg problem, expectations for additional capital gains can be another factor. That is, whereas the return is negative for an investor holding the bond to maturity, for those with shorter term investment horizons, the attractiveness might lay in the capital gains achievable if yields dip further into negative territory. Such a scenario is particularly relevant at the moment because the ECB’s buying spree comes in a time of tight budget deficit targets (ie. low issuance) resulting in unbalanced supply-demand. This argument also ties in with the first one, in the sense that institutional investors such as banks, could look to boost their profits by stepping up their sovereign bond holdings; indeed the beneficial effects that the QE programme can have on banks’ balance sheet is one of the reasons for its spread.

Expectations for FX gains can offset the negative yields and hence result in positive total returns. This is certainly not one of the drivers at work now in Europe as there appears to be limited room for a rebound in EUR as long as the ECB is committed to more money printing (as with anything else, larger supply pushes prices lower and in this case the price is the exchange rate). However, this was one of the possible explanations for the slip into negative territory of the 2 year German yields during 2012; at that moment speculations around a possible breakup of the Euroarea enhanced the attractiveness of the German bonds because in such an event a return to the Deutsche Mark would have resulted in FX gains.

The flight to safety can also result in a sizable uptick in demand, pushing yields below zero. An example was the banking crisis in the US when the lack of confidence in the banking system resulted in a retreat into Government bonds and the short term yields turned negative.

Fears of deflation also have the potential of pushing yields to negative levels. This is because in such an environment one would still have positive returns when adjusted for inflation. To take an example, starting from a EUR105 cash balance and a negative yield of 5% for a one year bond, the investor would have EUR100 at the end of the year; assuming that in the meantime prices fell by 10%, say from 10 to 9, this investment would have still increased the purchasing power by allowing the buyer to purchase 11 units instead of 10.5 units a year earlier. Such considerations are particularly relevant for large cash holders such as multinational corporations.

At the moment in Europe the negative yields reflect the power of the first three drivers I listed above and the strength of the trend supports my view that European government bonds will have a strong year, most notably because of the ECB intervention. In contrast to the similar measures taken by the US and UK, the European QE programme is met with stringent fiscal targets; Germany is forecasted to have a small budget surplus this year while the US had deficits of more than 8% of GDP when its central bank (Fed) started buying government paper. This is to say that the bond issuance in the US was high as well when the Fed stepped in and hence the supply-demand balance was more equilibrated.

Another reason for my optimistic view is that for the QE programme to spill into the economy it needs to drive yields well below the inflation rate so as to incentivise investments and bank lending. In the US for instance the long term real rates (after adjusting for inflation) fell to -2% during the QE. In Europe we are still far off even if we consider the inflation expectation rather than the current inflation rates.

As the negative rates prevailing now at the short end of the curves will likely push investors into longer maturities for some pickup in spreads, my view is that one should favour the longer dated bonds at this stage (maturities over 7 years). Such a strategy can be implemented through single bonds or ETFs. Among the latter I mention the Lyxor UCITS IG Eurozone Government Bond ETFs tracking indices with maturities of 7-10 years (MTD FP), 10-15 years (MTE FP) or over 15 years (MTF FP); yesterday these were up by 0.8%, 0.85% and 1.43% respectively.

Have a nice day!

Raluca