(Forbes) A lot has been written recently about negatively yielding bonds in the press. In full disclosure, this author has been writing about negatively yielding bonds for almost five years, though what seemed like a conundrum in the beginning has become all too normal for professionals today.
But now that this “anomaly” has caught the attention of the common public, we can be sure that there will be many arguments coming out on both sides of the debate, many of which will rationalize what others consider irrational. Indeed, just in the last day I have seen viewpoints on why negatively yielding bond markets mark the top of the bond bubble similar to the dotcom crash in tech stocks in 2000, and also arguments taking the other side, saying why negative yields may be normal in a world of excess savings, extended lifespans and excess wealth. Regardless, I will say that the current level of negative yields in trillions of bonds is perhaps the biggest event of my financial career.
Here I will focus on one specific group buying these negatively yielding bonds and what that potentially means for investors. In a previous note in this forum I wrote how through currency hedging negatively yielding bonds can be turned into positively yielding ones, and how positive yielding bonds can be turned into negatively yielding ones. The argument is simple. For example, let’s take a German ten-year Bund at -0.5% yield, and hedge the Euro currency back to dollars using a forward currency hedge. Since the interest rate differential as implied in the currency forward is approximately 2.5%, this turns the -0.5% into +2%.
This led me to ask who would be sophisticated enough to engage in this “arbitrage”, knowing very well that it is based on the use of a currency derivative contract, with the risks of such derivatives, including associated rollover risk. So I dug a bit deeper into this and not surprisingly, to a large degree the old mantra held up again: “I saw the enemy and the enemy is us”!
Let me explain with a couple of examples and some details. All data and information in this article is sourced from the Bloomberg terminal.
The first example is the German ten year benchmark Bund. It carries a coupon of zero, matures in August of 2029, and has a yield of -0.56%. To get its price, the bond math is super simple. The modified duration of a zero-coupon bond is roughly equal to its maturity. So you take ten times the yield and add that to 100 to get a price of 105.82 (the additional amount is due to bond "convexity"). In other words, the upfront cost of insurance that the buyer of this bond is paying to the German government is about 5.8%. The insurance policy assures the buyer that the German government will pay back the principal of 100 in ten years, for an “insurance fee” of 5.8. It is as simple as that - buying the bond at a price above par means the buyer is paying a premium for insurance. Since the price of insurance moves up or down based on demand and supply, it is hard to say if this is a high price or low price, without knowing much more about the likelihood of outcomes for which this insurance is being transacted. For instance, if all of Europe implodes in the next ten years, this might be a “cheap” insurance policy. On the other hand, if central banks and governments are successful in creating inflation, this might be a very high price to pay, since the 100 received at maturity will be worth less “real” money as the value of the currency in which the principal is paid would be worth less.
This particular bond was issued just recently at a price of 102.64 (the issue price was higher than 100 since at issue the yield was already lower than 0 at -0.26%). A total of 7 billion Euro was issued. Of this Euro 7 billion, Euro 1.5 billion was retained for “market intervention”, leaving a float of Euro 5.5BN. So who owns the rest? While I don’t have details on each holder, a search through my Bloomberg shows that a decent amount is owned by indexed bond funds based in the U.S. Of these funds, the ETFs who own them have to post the holdings daily for anyone to see. And there they are, lurking in your IRA, 401K or broker account. While many of the diversified global bond funds have more than five thousand individual securities, they all have to buy the bonds. One fund, for instance the Vanguard BNDX fund, is currency hedged, which we discussed above. Of course there are others as well, and most people point to demand out of Japan, where yields are negative as well, but about half a percent less negative than in Europe. So from the perspective of Japanese investors, it is better to buy the European bonds on a currency hedged basis than similar U.S. bonds.
Another example that has been in the popular blogosphere and which is being compared to tulips and bitcoin is of the Austrian 100-year government bond (RAGB 2.1 of 9/2117). This bond has a current yield of 0.80%, and a modified duration of 55, which means that even without adding in the bond convexity (which is “huge”) the bond moves over 70% in price return terms for a fall or rise in yield of 1%. So not surprisingly, as yields have fallen this bond is currently at a price of 186 with a face value of 100. At issue, it was 5.8 Billion Euros in total issuance, which is relatively small given the size of global bond markets. In a given week, this bond trades on average about Euro 8-10 million in size. Again, my Bloomberg terminal lists various index funds in the U.S. as the largest holders, and as I dig in deeper, I found that the Vanguard BNDX ETF owns a small amount (about one week’s trading volume of this bond). Since 100-year bonds of AAA countries are a rarity, if this is in your index you have to have it at any cost, not unlike those rare tulips of yester-years. There is almost no way to replicate the convexity of this bond without leverage, which is prohibited by most bond ETFs. So if your tulip...er...bond collection is to be complete, you will need this bond at any cost! And yes, a yield movement of about 0.02 percent (2 basis points) up wipes out a year of yield (e.g. from 0.80 to 0.82 percent). Not for the weak of heart.
There are three main points that follow from this discussion:
First, if U.S. indexed bond funds are the largest U.S. buyers of global negative yielding bonds, then they could, at some future point in time, be the sellers of these same bonds. This could happen if they decide that the yield on the bond fund is not sufficient compensation for the capital risk they are taking. The indicated yield, for instance, on BNDX is 1.1%, and its duration is around 8.3, so a roughly 0.13% move in the global yield curve wipes out a year’s worth of yield. That’s a pretty skinny margin of error. Some of the tulip like bonds will trade like, well, tulips, once they are no longer fresh.
Second, since financial alchemy is what converts the low or negative yields into positive yields, any compression in cross-currency rate differentials can result in hastening the fall in the yield in these funds, since currency hedging cannot provide the additional “yield”. To this point, an aggressive cut by the Fed that reduces the difference between U.S. and foreign yields could result in a lower hedged yield. If the Fed cuts 50 basis points in the next meeting, suddenly the U.S. bond market could attract the attention of currency hedged investors out of Japan as well. A massive re-allocation out of European negatively yielding bonds then could result in the convergence of the yield spread between European bonds and U.S. bonds. Could this mean the start of another round of European debt problems that won't have a simple monetary cure this time since yield levels are so low already?
Third, and most important, is the fact that the virtuous cycle of easy monetary policy and no inflation in the aftermath of the financial crisis has sucked money into bond funds at an incredible place. As trillions of dollars of cash have been created out of thin air by central banks, a large hoard of bond market holdings via low cost, passive indexed bond funds and ETFs has been the preferred way for both retail funds and many institutional investors to obtain exposure. The providers of the index funds do exactly what they say they will do; i.e. buy the bonds according to the weight in the index, regardless of price or future return prospects. The risk is that this virtuous cycle turns into a vicious cycle where they are forced to do what they have to do by the terms of their prospectus. If the bond market hits a rough patch, and investors exit their indexed bond funds, there will likely be indiscriminate selling of the individual bonds as well. This latent illiquidity of indexed bond ETFs has been only visible a few times in the past, and when it happens it is not pretty. The last time we saw a stampede out of an ETF was in February of 2018, when the volatility selling ETF XIV went from hero to essentially zero overnight. Clearly an indexed bond fund would hold up better than a levered VIX futures ETF, but we simply don’t know how much better.
So the takeaway is this: Only time will tell whether buying bonds at record low yield levels and record high prices is a good investment. I can argue both sides like all good two-handed economists even though I am not one myself. However, one thing seems clear – a large fraction of bond buyers are probably buying them on autopilot, paying little attention to yields. As long as the price of the bond is going up, it is hard to argue with doing more of the same since the value of the holder's account is probably going up. We simply have to watch and see what happens once and if the tide turns. In the meantime, investors may want to consider getting out of indexed bond funds that own negatively yielding bonds and instead, consider buying some good old-fashioned treasury bills that currently yield almost twice as much! As they say, being passive is also an active decision, especially when it comes to being a creditor, which is what one is when investing in a bond fund.