Negative yields in Bond

Negative yields in Bond
Negative yields on bonds are no longer a new experience. In Switzerland, Germany, Denmark and several other European countries, government bonds are trading at negative nominal yields. There are four potential reasons that can explain the negative yield and can also illustrate the trade-offs between different investment strategies.

First and foremost, negative yields could simply be a consequence of active monetary policy (with goal of stimulating economic activity) in a world where bond supply and demand is not balanced. It is certainly possible for negative short-term deposit rates in concert with central bank purchases of scarce fixed income assets to drive bond yields negative; policymakers, in fact, hope that this development will drive investors out of “safer” government bonds into other riskier assets. Central banks in majordeveloped economies have amassed close to $10 trillion in government bonds since 2004, and still remain a source of demand of close to $3 trillion more a year. Meanwhile, the net issuance of government bonds of about $2.5 trillion has been on the decline. This demand mismatch is likely one of the reasons there are $3.6 trillion in bonds outstanding trading at a negative yield (or about 16 percent
of the outstanding government bond universe).

Second, negative yields could potentially be correctly forecasting a sharp economic slowdown, which, as a consequence, could lead to an increase in defaults (both corporate and sovereign) in the future. Paying up now and receiving less nominal money in the future can be profitable if the price of goods has fallen sufficiently. Defaults and deflation usually go hand in hand. In such a scenario, the return of money becomes more important than the return on money. If this is true, then the premium above the face value one pays for a zero-coupon cash flow is the “insurance premium” for a perceived higher likelihood of the return of invested capital. Investors are risk averse in the aftermath of the financial crisis and it is not irrational for them to seek assets they perceive to be highly liquid and “safe” in an effort to protect themselves against the repeat of losses incurred in the aftermath of the crisis. For
example foreign banks have 17 billion Swiss francs in deposits at the Swiss Central Bank at a deposit rate of -0.75%, while yields are as low as -0.15% for a 10-year bond, and this is not likely invested for returns on capital, it is more likely an effort to protect capital and liquidity.

If the low or negative yields are signaling a sharp slowdown in the economy to come, then we should ignore the cosmetic levels of yields and buy the government bond market, since yields (and total returns once we capture roll down on the yield curve) are likely to be positive and persistent in this scenario. (To wit, the Japanese government bond market has been one of the best performers on a risk-adjusted basis over the last decade despite persistently low yields, as short-term yields have remained low and the purchase of longer maturity bonds has resulted in investors earning the duration risk premium).

Third, negative yields could also be a consequence of the ecology of current market participants.
Choosing to not own these government bonds as an active allocation decision can (even with good cause due to their negative yields) carry risk for certain investors – e.g., the potential for higher tracking error to their benchmark or under performance versus their peers. That said, as government bonds have an increased representation in many bond indexes that are used as benchmarks, holding these bonds tostay close to the benchmark also carries a cost: lower absolute returns due to a portfolio with an increasing component of negative return. And this cycle reinforces itself: As continued investor demand meets fewer new bonds available to match indexes, investors may have to accept this cost in order to manage risk versus their benchmarks

And finally, in very broad terms, aggressive central bank intervention with negative interest rates continues to underwrite risk taking. So, if/as rates go more negative, an asset allocation of long equity risk versus core government bond duration remains a challenge.

Since US election in November 2016 total market cap of world stock market has gone up by $3Trillion and global market cap of bond market has gone down by $3Trillion….
By Pankaj Sahay