The threat of regional deflation looms large, increasing the demand for safer fixed income, while investors are positioning themselves ahead of ECB’s €1.1 trillion (€60 billion/month) QE bond-buying program designed to drive down borrowing costs across the troubled region and stimulate growth and inflation. This implies the central bank is primed to start buying from a shrinking pool of positive-yielding securities. While once the preserve of short-dated sovereign paper, negative yields are creeping ever further up the maturity duration ladder with benchmark 10-year bonds yielding record lows in many instances.
Germany recently auctioned five year debt with a negative yield, joining Finland, while highly rated corporates such as Nestle (NSRGY) and Royal Dutch Shell (RDSA) recently experienced the rare event of their own debt yields trading below water, albeit only briefly. European countries with sub-zero yields of at least some duration now include Germany, Denmark, The Netherlands, Sweden and Austria. While many of these historically traded with low debt yields thanks to demand for their safe-haven status, interest has soared as investors look to the possibility of capital gains as opposed to mere cash preservation/stable returns via longer-term investment.
Just Like a Share?
Much like the dividend yield on an equity, the coupon yield on a bond moves inversely to its price. The higher the price of the bond rises, the more the percentage return from the ‘fixed income’ coupons decreases. Once the market price paid exceeds the total return from the principal to be redeemed at maturity and the remaining coupons, buyers are in effect paying for the privilege of lending money to the corporate/sovereign borrower. This is a loss worth taking if deflation is rife and central banks such as the ECB are charging even more for the privilege of safely parking excess funds.
But a Guaranteed Loss?!
- The negative yield relates to the return if the bond is held to maturity, of which there is no obligation, and until then in there is usually at least some income - albeit limited - to be received regularly.
- If the price of the bond keeps rising capital gains can be made short-term.
- For those with the ability to borrow Euros at exceptionally low rates, profits can be made from even small short-term capital gains if greater than the interest paid to borrow the Euros.
- Should the ECB prove successful, stimulating inflation and a recovery by the EUR, there is potential for gains to be made on the currency side of the trade too when exchanging back from EUR into other currencies such as the USD or GBP.
- If you expect to lose money anyway, a smaller loss from a negative yielding bond can in effect be a better relative result.
So we have a troubled Eurozone and a late-to-the-QE-party ECB to thank for this shift in the Bond market. Its plan to intervene in European bond markets has seen prices rise as investors react, hoping to profit from the new big buyer in town driving prices even higher. In contrast to normal times, the sector is seeing investors act more like traders, focused on bigger than usual capital gains and FX/interest rate arbitrage on highly-rated debt rather than the plain vanilla fixed income usually desired to guarantee safety during market ups and downs. Thanks for keeping things interesting, Mr. Draghi.
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