One only has to look at Eurozone government bond markets, where a significant maturity segment – such as up to five years in the case of Germany – is trading at negative yields, to realise that these are truly unusual times. In effect, investors are signalling a willingness to pay for the privilege of holding a government bond. Surely, that cannot be rational behaviour, can it?
Well, it depends. In times of severe market stress, one where for example there is also little confidence in the solvency of banks, it might make perfect sense to pay a small fee to a highly creditworthy sovereign in order to ensure the preservation of most of one’s capital.
But even in less extreme times, a negative yield does not necessarily mean investors are in for a loss. Indeed, fixed income investors should never overlook that a yield is associated to a price, and these move inversely. The bond price/yield combo is the ultimate expression of supply and demand dynamics for the bond in the market. If demand outstrips supply, the price of the bond goes up and the yield comes down.
In the current environment of zero-hugging interest rates in the Eurozone, it should not surprise to see bond yields for short, and even medium-dated, maturities in negative terrain. Rather, the more pertinent question is why, despite what at first sight may look like a net losing proposition, investors show an inclination to pile into Eurozone sovereign debt. Well, there are a number of reasons, of which perhaps the most relevant are the following:
ECB Monetary Policy Activism
The ECB is embarking in an open-ended programme of quantitative easing whereby it intends to buy EUR 60bn worth of Eurozone sovereign bonds per month until at least September 2016. In short, there is now a power buyer of bonds in town, with theoretically unlimited bags of cash, and so investors rationally assume that capital appreciation (i.e. bond price increases) might more than offset the downside in yields.
Deflation
A bit of an economic nightmare, but with a silver lining for investors. In order to measure the real success of an investment, one must account for the eroding effects of inflation. If, as is the case in the Eurozone right now, inflation is negative and is expected to remain so for a while, then, bingo!, instead of eroding, it boosts real returns.
So, investors in short-to-medium dated Eurozone government bonds may not be behaving that irrationally after all. In fact, as the following table shows, the total return net of ongoing charges for exchange-traded-funds (ETFs) tracking the performance of Eurozone short-dated government bond indices both in February alone and in the first two months of 2015 was positive. This was the case even for ETFs providing sole exposure to the uber-creditworthy German sovereign market where the negativity of yields is more pronounced. And this is before one takes into consideration the boosting effect of deflation on real returns.
Needless to say, this is not for everybody; certainly not for non-EUR investors. The value of the Euro is on a declining path against other currencies. And so, any potential upside via capital appreciation would have been more than wiped out by unfriendly FX considerations. But even for EUR-denominated investors where FX does not come into the equation, this comes with a limited shelf-life, which is determined by the set of unusual circumstances remaining firmly in place. And one has to judge this as somehow unlikely. Amongst other things, if the ECB is embarking in QE is precisely to bring inflation back up to positive terrain.
In any case, the point is that, when it comes to fixed income investing, one must always scratch beneath the surface. As bewildering as it may seem, a negative bond yield is not necessarily a losing bet.
