THE Ice Age is defined as a period when the Earth experiences long period of sub-zero temperatures mainly due to climate change and rising sea levels as well as other factors.
In financial markets, we too have what is termed as Ice Age investing – a period when bond yields are below zero, brought about by a multitude of factors and holding cash as an asset becomes a liability due to very low or negative returns on cash. How investors manoeuvre themselves in generating positive returns in periods of negative returns is indeed challenging.
US$13 trillion – that’s the figure as to the total nominal value of global sovereign debt papers that are trading at negative yield now. In fact, that figure surpassed the previous record high of US$11.7 trillion in 2016, based on data compiled by Bloomberg. It is not just the sovereign debt papers that are now in sub-zero zone, negative yielding debt now represents almost a quarter of global investment-grade papers.
What is driving this euphoria towards sovereign papers? Does it make sense to hold sub-zero yield to maturity papers and what will it do to portfolio management of asset managers and investors?
The fixed income market rallied on the back of comments made by major central banks on the economic outlook driven by sustained concerns on trade war issues between the United States and China as well as a benign inflationary outlook. With economic data pointing towards slower momentum, central banks need to remain ahead of the curve to ensure the economy does not go into a tailspin and cause further loss in momentum.
Two weeks ago, when the European Central Bank signalled that it might lower interest rates and resume its bond-buying programme if inflation continued to be well below its 2% target, it led to another round of pressure among European sovereign papers with France, Austria and Sweden joining the sub-zero club. The average yield of the US$57 trillion global sovereign bond market is now just 1.67%, 88 basis points (bps) lower than the level seen in November last year at 2.51%.
In 2016, sovereign bonds dipped into sub-zero zone mainly due to the low interest rate environment globally. This was also at a time when the Fed and some other central banks had either started to raise rates or expected to do so as they were already at the bottom of the curve and the only way was up or to stay pat.
As most of them saw economic prosperity returning above the trend line, and along with it, higher inflationary expectations, driven by a tighter labour market and rising wages, the global bond market saw increasing pressure as yields rose.
Of course, we reached the previous record high in sub-zero rates mainly due to the flood of money via quantitative easing policies by major central banks which saw money chasing investments, be it bonds, equities (both public and private), properties and even non-traditional investments like art.
In fact, since 2016, and in just under three short years, the global equity and bond markets have increased in value by more than US$24 trillion. The current euphoria on markets was also driven by the fact that the Fed is no longer keen in reducing its balance sheet while market’s expectations of a rate cut is well priced-in with 100% probability of a 25bps cut by the end of this month, based on Fed fund futures prices. There is a 69.2% chance that another rate cut will take place in the Fed’s mid-September meeting and a 38.5% probability that the Fed will move down another 25bps in its December meeting, bringing total rate cuts to three for this year and as much as 75bps.
What sense does it make for investors to hold negative yielding papers? Negative yield basically means an investor is in actual fact having a negative return on his/her investments as the income earned from the coupon is insufficient to compensate for the capital loss upon maturity of the papers, even after taking into account the reinvested coupons that are received from the papers.
One way an investor can make money is via gains that can be realised from a currency perspective, i.e. if the investment in the fixed income paper is not in the home currency. For example, assuming an investor is a US dollar-based investor and the expectations are that the yen will continue to appreciate in the market against the dollar and hence the investor buys the samurai bonds on expectations that the capital loss from the investment will be offset by currency gains.
Another way the investor can realise a gain is if the investor thinks the sub-zero reading on the sovereign papers at a time of purchase will go deeper into the negative territory and he makes a capital gain on disposal. As yield and prices are inversely related, a -0.1% bond paper will rise in value if the yield drops to -0.2% and hence allowing the investor to realise a capital gain on investment plus the earned coupons for the holding period of the papers.
In essence, while buying sub-zero papers is deemed to be pointless, there are ways an investor can still make money, provided either he makes up the shortfall via a currency exposure or to realise a profit based on expectations of further deterioration in yield.
On a portfolio basis, for certain types of investors, especially pension and insurance funds, they have no choice but to remain exposed in this asset class as they are mandated to do so.
Of course, in certain cases, a low negative return is much better than a larger negative return in riskier asset classes, like equities, especially if the markets are already at the top-end of its valuation perspective and fear of a major pull-back could erode portfolio values even more.
In today’s environment, while the global bond yields are falling or into sub-zero, the majority of investors are finding it hard to realise a decent set of yield on their investment portfolio of even between 5% and 7% annually.
Hence, there has been a switch to riskier asset class and longer duration to get the extra returns compared with just sovereign exposure. In the fixed income market, investors are switching towards higher yielding paper, longer duration, emerging markets as well as non-rated papers to get that extra kick in their investments. As a portfolio, investors are adding equities (both public and private) to generate better returns. Hence, we are seeing more and more crowded trades along the lines of favoured stocks, both locally and globally, resulting in an overall PER expansion, despite lacklustre earnings growth.
For pension, life insurance and absolute return funds, it is even more challenging investing during a period of low or negative interest rates as it would mean taking a greater risk in investing to generate the expected returns. These funds, while able to outperform the market relatively speaking, will not be able to generate the absolute returns required to sustain its ability to deliver results that are expected and hence exposed to greater risk of non-performance. What can these investors do in these periods?
Large pension or insurance funds are not only investing in the traditional asset classes but non-traditional ones as they need to show absolute returns. Other than raising direct exposure in equities and in order to generate alpha, investors can opt to look to invest in direct hard assets, for example taking equity interest in profitable and promising unlisted businesses, private equity investing, hedge funds, real estate, direct infrastructure investing and assets with a definite lifespan but with lock-in cash flows such as toll operators, power plants, large scale solar plants, water treatment plants, cryptocurrencies or commodities.
Of course, all these investment choices carry different risk profiles and depending on the investors’ risk appetite as well as whether the investment mandates allows, they can provide decent rate of return if managed well.
Even gold, which yields zero return in terms of income, can provide a better return than sovereign papers as zero return is still better than negative returns. No wonder gold is up 10% year-to-date and much of the gains were posted in the past five weeks alone when yield on more sovereign papers dipped below zero.
The views expressed here are solely the opinion of the writer.