The Black Hole Engulfing the World's Bond Markets
By
July 13, 2019, 5:00 AM GMT+1
There’s a multitrillion-dollar black hole growing at the
heart of the world’s financial markets. Negative-yielding debt -- bonds worth
less, not more, if held to maturity -- is spreading to more corners of the bond
universe, destroying potential returns for investors and turning the system as
we know it on its head. Now that it looks like sub-zero bonds are here to stay,
there’s even more hand-wringing about the effects for mom-and-pop savers,
pensioners, investors, buyout firms and governments.
heart of the world’s financial markets. Negative-yielding debt -- bonds worth
less, not more, if held to maturity -- is spreading to more corners of the bond
universe, destroying potential returns for investors and turning the system as
we know it on its head. Now that it looks like sub-zero bonds are here to stay,
there’s even more hand-wringing about the effects for mom-and-pop savers,
pensioners, investors, buyout firms and governments.
1. Why invest in a bond that will lose you money?
Typically, bonds are the safest assets on the market, so
many investors seek them out at times of heightened market stress, say a
U.S.-China trade war or tensions in the Persian Gulf. A bond can have a
modestly positive coupon when issued by a government, institution or company,
but once it starts trading, high demand by investors can push its price up --
and therefore its yield down -- to such an extent that buyers no longer receive
any payment. Some funds track government bond indexes, meaning they must buy
the bonds regardless of the yield. And some investors can still make positive
returns on these bonds when adjusted for currency swings.
many investors seek them out at times of heightened market stress, say a
U.S.-China trade war or tensions in the Persian Gulf. A bond can have a
modestly positive coupon when issued by a government, institution or company,
but once it starts trading, high demand by investors can push its price up --
and therefore its yield down -- to such an extent that buyers no longer receive
any payment. Some funds track government bond indexes, meaning they must buy
the bonds regardless of the yield. And some investors can still make positive
returns on these bonds when adjusted for currency swings.
2. How much is being bought?
Negative-yielding debt topped $13 trillion in June, having
doubled since December, and now makes up around 25% of global debt. In Germany,
85% of the government bond market is under water. That means investors
effectively pay the German government 0.2% for the privilege of buying its
benchmark bonds; the government keeps 2 euros for every 1,000 euros borrowed
over a period of 10 years. The U.S. is one of the few outliers, with none of
its $16 trillion debt pile yielding less than zero, but across the world,
strategists are warning that the problem may get worse.
doubled since December, and now makes up around 25% of global debt. In Germany,
85% of the government bond market is under water. That means investors
effectively pay the German government 0.2% for the privilege of buying its
benchmark bonds; the government keeps 2 euros for every 1,000 euros borrowed
over a period of 10 years. The U.S. is one of the few outliers, with none of
its $16 trillion debt pile yielding less than zero, but across the world,
strategists are warning that the problem may get worse.
3. Why is this reason for worry?
Negative rates are at odds with basic principles of the
global finance system. “One important law of financial logic –- if you lend
money for longer, you should see a higher return –- has been broken,” wrote
Marcus Ashworth, a Bloomberg Opinion columnist covering European markets. “The
time value of money has essentially disappeared.” (Has it ever: The so-called
century bonds issued by Austria two years ago, which mature in 2117 and
initially offered a 2.1% return, now yield about 1.2%.) All this can push
investors into riskier bets in the hunt for returns, raising the chances of
bubbles in financial markets and real estate.
global finance system. “One important law of financial logic –- if you lend
money for longer, you should see a higher return –- has been broken,” wrote
Marcus Ashworth, a Bloomberg Opinion columnist covering European markets. “The
time value of money has essentially disappeared.” (Has it ever: The so-called
century bonds issued by Austria two years ago, which mature in 2117 and
initially offered a 2.1% return, now yield about 1.2%.) All this can push
investors into riskier bets in the hunt for returns, raising the chances of
bubbles in financial markets and real estate.
4. Who benefits from negative rates?
Governments, for one. The incentive to borrow money is never
greater than when you are being paid to do so. Germany, for example, is being
subsidized to issue debt over the next 20 years, though that does not
necessarily mean it will boost spending. Companies that issue bonds also reap
the benefits of record-low borrowing costs. So do private-equity firms, which
typically use leverage to acquire companies and see greater opportunities when
(and where) capital is cheap. Homeowners with variable-rate mortgages also have
reason to celebrate.
greater than when you are being paid to do so. Germany, for example, is being
subsidized to issue debt over the next 20 years, though that does not
necessarily mean it will boost spending. Companies that issue bonds also reap
the benefits of record-low borrowing costs. So do private-equity firms, which
typically use leverage to acquire companies and see greater opportunities when
(and where) capital is cheap. Homeowners with variable-rate mortgages also have
reason to celebrate.
5. Who gets hurt?
Pension funds and insurers, traditionally big investors in
government bonds, are in a particular predicament: Their liabilities grow
steadily as clients age, but often they are required not to take on big risks.
Banks see their margins squeezed. They’re earning next to nothing from lending
but still need to offer depositors a rate above zero to keep their business. In
Germany, the ECB has come under political pressure for hurting the returns of
savers. Central banks could run into the problem of hitting the so-called
“reversal rate” -- the point at which low borrowing costs start to harm rather
than help the economy, should banks start to restrict loans. That could deepen
any slowdown.
government bonds, are in a particular predicament: Their liabilities grow
steadily as clients age, but often they are required not to take on big risks.
Banks see their margins squeezed. They’re earning next to nothing from lending
but still need to offer depositors a rate above zero to keep their business. In
Germany, the ECB has come under political pressure for hurting the returns of
savers. Central banks could run into the problem of hitting the so-called
“reversal rate” -- the point at which low borrowing costs start to harm rather
than help the economy, should banks start to restrict loans. That could deepen
any slowdown.
6. How did we get here?
Several of Europe’s central banks, otherwise unable to spur
growth in the aftermath of the 2008-2009 financial crisis, cut interest rates
below zero in 2014. Japan soon followed. The idea was to spur lending by
charging financial institutions, rather than rewarding them, for parking money
that otherwise could be put to use in the real economy. Since 2016, the ECB’s
benchmark rate has been -0.4%, meaning banks lose 4 euros to store 1,000 euros
there. The sub-zero rates were supposed to be temporary but have endured.
Traders are betting that the ECB will push its deposit rate ever more negative
this year, driving record levels of bond yields below zero.
growth in the aftermath of the 2008-2009 financial crisis, cut interest rates
below zero in 2014. Japan soon followed. The idea was to spur lending by
charging financial institutions, rather than rewarding them, for parking money
that otherwise could be put to use in the real economy. Since 2016, the ECB’s
benchmark rate has been -0.4%, meaning banks lose 4 euros to store 1,000 euros
there. The sub-zero rates were supposed to be temporary but have endured.
Traders are betting that the ECB will push its deposit rate ever more negative
this year, driving record levels of bond yields below zero.
7. Why have negative rates lasted so long?
More than a decade on from the credit crisis, inflation is still
scarce, with wages increasing only modestly despite large drops in
unemployment. The ECB, for example, isn’t expected to get to its close-to-2%
inflation target over the next decade, according to a market-derived measure.
And the yield difference between U.S. three-month bills and 10-year Treasuries
is inverted, an indication that an economic contraction may be coming. Aside
from the U.S. Federal Reserve, few central banks that slashed interest rates
during the credit crunch have managed to raise rates, meaning that during the
next downturn they are likely to head further into negative territory.
scarce, with wages increasing only modestly despite large drops in
unemployment. The ECB, for example, isn’t expected to get to its close-to-2%
inflation target over the next decade, according to a market-derived measure.
And the yield difference between U.S. three-month bills and 10-year Treasuries
is inverted, an indication that an economic contraction may be coming. Aside
from the U.S. Federal Reserve, few central banks that slashed interest rates
during the credit crunch have managed to raise rates, meaning that during the
next downturn they are likely to head further into negative territory.
8. Where’s all this heading?
In Europe, there are fears that the continent is following
the path of Japan’s so-called lost decade, where policy makers struggled to
revive anemic growth and inflation. Central banks have been keen to iterate
that they still have tools in their locker to combat any slowdown, including
rate cuts and more quantitative easing. For markets, waning volatility is bad
for trading. Geopolitical tensions over trade, and Britain’s exit of the
European Union will keep driving investors into the safest assets, meaning
demand will remain high for negative-yielding debt. But the push to find
juicier returns with riskier bets raises the prospect of further fund failures
or a new crisis.
the path of Japan’s so-called lost decade, where policy makers struggled to
revive anemic growth and inflation. Central banks have been keen to iterate
that they still have tools in their locker to combat any slowdown, including
rate cuts and more quantitative easing. For markets, waning volatility is bad
for trading. Geopolitical tensions over trade, and Britain’s exit of the
European Union will keep driving investors into the safest assets, meaning
demand will remain high for negative-yielding debt. But the push to find
juicier returns with riskier bets raises the prospect of further fund failures
or a new crisis.
The Reference Shelf
Why buyers of negative-yielding debt aren’t necessarily
fools.
fools.
QuickTakes on negative interest rates, yield curve inversion
and central bank independence.
and central bank independence.
Bloomberg Opinion columnist Marcus Ashworth delved into the
implications of "this tectonic shift in fixed income."
implications of "this tectonic shift in fixed income."
The crisis at Danske Bank illustrates the full extent of
damage from negative rates.
damage from negative rates.
An ECB paper on negative rates not being unproductive once
they reach the zero lower bound.
they reach the zero lower bound.
Pimco are among a growing clamor of voices that Europe is
becoming “Japanified.”
becoming “Japanified.”
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