Last June the European Central Bank (ECB) cut its deposit rate to minus 0.10% and yields on eurozone government bonds set course for sub- zero territory. When this deposit rate was cut further to minus 0.20% on 4th September 2014, about €1trillion out of the €5trillion eurozone government debt market had negative yields. Bank of America Merrill Lynch further estimates that by late February 2015, after the ECB announced its quantitative easing (QE) program on January 22nd, this €1.0trillion had doubled. And, a scant six weeks after the launch of the ECB’s QE campaign on March 9th, €2.8trillion of eurozone government debt offers negative yields.
This new paradigm signals a sea change in the mindset of bond investors. With negative yielding debt, investors are guaranteed a loss of invested capital if the bonds are held to maturity. Returns on these bonds are positive only if inflation is persistently lower than the yield and/or the price of the bond continues to climb higher. The eurozone’s inflation rate was minus 0.1% last month. A bond that carries a nominal yield of minus 0.05% gives a real positive yield of 0.05% after adjusting for the minus 0.1% inflation. Investors’ willingness to settle for low/negative yields suggests expectations of (i) persistent low inflation; (ii) lacklustre growth; (iii) growing debt- servicing problems; and (iv) higher credit default risk. Hence, as PIMCO points out in its February 2015 Viewpoint, the “return of money is more important than the return on money”.
As for bond prices, the ECB’s QE move is squeezing the already shrinking supply of highly rated eurozone government debt. Reflecting this, German bunds have carried negative yields since February. On 10th April, German 10-year bunds yielded 0.16% and fixed income managers like PIMCO’s Bosomworth predicts the yield will dip below zero soon. As the pool of eurozone government debt dries up, Bloomberg reports on 24th April that the ECB has begun to buy covered bonds with negative yields. (Broadly, covered bonds are debt securities backed by cash flows from mortgages or public sector loans.) Bond prices will continue to be supported in the face of ECB demand and investors’ reluctance to sell.
Sub-zero yields are likely to remain a feature of the eurozone government bonds market.
Negative yields have driven institutional investors to take on more risk to boost returns. Bloomberg reports on 23rd March that Norway’s Norges Bank Investment Management, the world’s biggest sovereign wealth fund, has increased its holdings of corporate debt rated BBB or lower and added bonds issued by Petroleo Brasiliero SA, Ghana and Mauritius. Allianz SE, Europe’s largest insurer, has moved into commercial mortgage loans, infrastructure debt and emerging markets. And, the same Bloomberg report states that JP Morgan’s Global Bond Opportunities Fund has about 75% invested in speculative grade or unrated debt securities.
We continue to lean towards investing in companies with solid business fundamentals both in the equity and fixed income space to generate portfolio returns. However, to ensure access to market liquidity, we would allocate to highly rated government bonds despite the dismally low yields. The recently announced Singapore Savings Bonds is a candidate in this space.
We prefer at this stage to safeguard capital and market liquidity.