Varecon 01

Ltd

It is difficult to find any discussion or analysis of negative bond yields without a commentator or analyst metaphorically scratching his/her head and exclaiming that it simply does not make any sense. Why, we are continuously being asked, would anybody give money to a government and be willing to receive less over, say, a ten year period, than was invested? Have these investors not considered inflation and the obvious risk that it might rise, perhaps causing the real returns to be very significantly negative? Yet, for the past five years at least, the same analysts were telling the markets that they should be selling bonds rather than buying them – as the yields were simply too low and were more likely to rise than to fall further. Throughout this period, this has turned out to be one of the worst pieces of investment advice that one could been given, with falling yields causing government bonds to produce some of the best returns of any asset class. Allied to this advice were forecasts that inflation was about to take-off – about nine months’ time from the forecast, whenever it was made – and that, in turn, would force interest rates to be raised by the central bank. Bond investors typically ignored the economists’ and analysts’ advice and continued to buy. Even when the Bank of England embarked on a modest phase of (probably misguided) quantitative easing post the Brexit vote, and was willing to pay a premium to buy in bonds, there was a reluctance by the institutions to sell their gilt holdings to the Bank at record or close-to-record low yields. Whenever I feel the temptation to believe that the market is being stupid, I sit down, take a breath and think to myself maybe I am the one that is just about to be stupid. So, let me provide a rationalisation of market activity and three explanations why investors are willing to continue to buy (or hold, which is the same thing) bonds at exceptionally low or negative yields. 1. Some investors are just concerned about preserving their capital; these are the most risk-averse. It is possible to deposit the capital in a bank and there are EU bank guarantee schemes, but they only provides support up to EUR100,000 for one’s accounts at each bank. (Institutions who held Icelandic bank accounts will vouch for the limitations of the scheme.) Some banks are starting to charge large depositors for holding their cash and sometimes it is surprisingly difficult to withdraw the money when required: Greece is an obvious example but there were ‘unofficial’ limitations placed by EU banks at various points over the past seven years as they seek to retain customers’ monies to help their cash flows. Bonds give an explicit government guarantee and, for those who need certainty about their returns (such as liability-matching pension funds) or just want to remain rich, government bonds can meet their needs. 2. Academic studies validate momentum investing as a strategy to achieve outperformance. Given that government bonds have been one of the outperforming asset classes, there is an argument to continue to buy and hold bonds in the expectation for further outperformance. It was only a couple of years ago when economists and academics argued that negative yields were a virtual impossibility, so there is no logical argument to say that bond yields cannot fall further. Of course, at some point the price trend will reach an inflection point and establish a downward momentum, but government bonds are about the most liquid asset class and investors can shift back into cash very quickly. While few investors will get out at the top of the market, that applies to most investments. A complete market collapse is theoretically possible, but extremely unlikely given the amount of quantitative easing still being implemenmted by many central banks. What other asset classs provides such underwriting of performance? 3. It is usually not made clear, but the yields being discussed in reports and the media are actually the gross redemption yields of the bonds. The word ‘gross’ is a reference to tax and the word ‘redemption’ refers to the calculated annualised return taking into account both the coupons from the bonds and the maturity value of the bonds. The returned maturity value may be less than the purchase price, but the coupons will always be positive. Over the life of a 10-year government bond, the investor will receive a stream of income. And, because many government bonds were issued at times when yields were relatively high, the gap between the gross redemption yield and the flat or running yield (the income yield) can now be quite significant. It is not uncommon to have, say, a 0.5% gross redemption yield, but a 2% running yield. Yes, there will be a capital loss at the point of maturity but this is on the assumption that the bonds are held to maturity. Those investors who continuously swap into longer maturities as the bonds age can defer that point.

Bond investors typically ignored the economists’ and analysts’ advice and continued to buy