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Fixed-Income Insights

Yields on government debt in the eurozone and elsewhere recently dipped below zero. Here's what it could mean for investors.

 

In Brief

▪ Weak regional economies and ultra-easy monetary policy recently helped push certain eurozone government bond yields into negative territory.

▪ Amid the market uncertainty caused by negative rates, investors likely are focused on four main questions:
- Can negative yields continue?
- Who invests in negative yields?
- Are negative yields the "new normal"?
- How might it all end?

▪ The key takeaway—The distortions and consequences of negative yields could influence investment values for some time. But this phenomenon is not likely to be the "new normal," and its reversal likely will be characterized with volatility.

 

Weak economic data, fear of deflation, and ultra-accommodative central bank policies enabled the eurozone to achieve perhaps a global first last summer: negative yields on government debt. (Even Japan, mired in two decades of economic stagnation, did not reach that milestone until November 2014.) This particular rendition of "Less Than Zero" began with isolated instances in August 2014, but during the first quarter of 2015 spread like a virus to affect the debt of numerous European countries—and a variety of bond maturities as far out as 13 years.

By early February 2015, Austria, Finland, Sweden, and the Netherlands each had negative yields on their debt with maturities out as long as five years. Negative yields extended to debt maturities as long as nine years in both Denmark and Germany in April. And Switzerland, which recently sold $242 million of 10-year debt at -0.055%, carries a negative yield on bonds as long as 13 years. According to a Reuters report on April 8, a third of eurozone government debt carried a negative yield. While yields on Eurozone government debt have recently climbed back above zero, the conditions that caused this phenomenon are still in place.

The phenomenon has influenced the corporate market as well. European debt from companies such as Nestlé, General Electric, and Royal Dutch Shell briefly traded at negative yields earlier in 2015, according to Bloomberg. So far, negative yields have not yet surfaced among traditional, dollar-denominated U.S. bonds; however, strength in the U.S. dollar and a trend toward narrower credit spreads since the beginning of the year suggests that negative yields in the eurozone may be supporting investment flows to U.S. debt with more attractive yields. 

Low rates in Europe also are influencing U.S. debt in another way: U.S. companies that want to lower their borrowing costs have been offering local currency debt in the eurozone. Coca-Cola, AT&T, and Kinder Morgan have been among U.S. companies that have taken advantage of low yields in the eurozone to issue debt there instead of the United States. This has caused a chain reaction in the U.S. market. The reduction in the supply of U.S. corporate debt lowers the yield on U.S. corporate bonds if there is no change in demand. U.S. corporate bond supply could be further reduced and yield could subsequently fall if such eurozone financing is used to pay down existing, higher-coupon U.S. debt.

As you can see, the arrival of negative yields in the global investing landscape carries enormous implications for fixed-income investors. Here, we’ll attempt to answer four pressing questions investors may have about this trend.

1) Can negative yields continue?
The ultra-easy policies of the European Central Bank (ECB) seem to assure pressure toward negative yields in Europe and a related impact on U.S. markets well into 2016. Austerity programs in Europe have reduced government-financing requirements, creating total net new supply of euro zone government debt of only €17 billion per month in 2014 and likely less in 2015, according to the ECB. Given that March marked the beginning of ECB purchases that are expected to continue at a pace of €60 billion per month through September 2016, negative yields seem likely to persist. The ECB’s quantitative easing (QE) program is anchored by a negative deposit rate of -0.20% that potentially enables a profit on any ECB purchases of debt at a yield of -0.19% or higher. An even more extreme deposit rate of -0.75% in Switzerland helps explain why negative yields are even more prevalent in that country.

2) Who invests in negative yields?
Other factors contributing to a continuation of negative yields include the expansion of exchange-traded funds and passively managed portfolios that purchase a representative slice of the bond market without regard for price or yield. Investors who expect deflation also find value and rationale in purchasing bonds with negative yield. If a decline in prices and a corresponding increase in purchasing power exceeds the loss of holding a bond that pays back less than what was invested, investing a negative yield can be economically justified. 

Similarly, investors concerned about the economic fate of Europe may take comfort in owning government debt, even if they are returned slightly less than what they invested. It seems the combined factors of significant ECB purchasing, austerity-driven reductions in supply, purchasing habits of passive management, and fears of economic distress and deflation support an environment that will continue to promote negative yields for some time to come.

3) Are negative yields the "new normal"?
While in Europe issues of supply (influenced by austerity programs from European governments) and demand (driven by the ECB’s QE effort) seem likely to keep yields negative at least until ECB bond buying stops, it is likely that negative yields are not sustainable. 

A look at the current environment supports that view. Financial repression is the term that describes the difficult environment savers face with few opportunities to safely earn returns that exceed inflation. Negative yields create financial regression, leaving savers with absolutely less than what they invested. Such an environment favors borrowers, such as the government, and hurts those dependent on income-producing investments, including institutions as well as individuals. In a negative-yield environment, life insurance companies and pension funds will struggle to stay afloat if there are no long-term, positive-yielding assets to match their liabilities. States with long-term unfunded liabilities will face not only a potential jump in the present value of those liabilities but also an inability to fund those liabilities with traditional fixed-income securities. Investments in negative-yielding assets would leave life insurance policies and pension funds with less value than what was contributed. 

Should the "below-zero" conditions prevail, companies that make those time-honored stores of value—safe deposit boxes and mattresses—could be part of the next wave of growth stocks. 

4) How might it all end?
The ECB has 90% of the funds earmarked for its purchase program as yet unspent. But negative yields are already creating financial regression for investors and, over a long period of time, threaten the financial infrastructure of insurance companies and pension funds. Of all the questions we’ve addressed, our last  one may prove to be the most important: How might the phenomenon of negative yields finally end?

Because negative yields represent a supply-demand imbalance, the end of ECB demand (i.e., the cessation of bond purchases) would be one event that could initiate a reversal of high bond prices and negative yields. The ECB currently is scheduled to complete its QE program in September 2016. Unless that schedule is modified, investor anticipation of reduced ECB demand could produce price weakness sometime prior to that date, allowing yields to rise. In this scenario, yields on European debt could stay negative throughout 2015 and well into 2016, before adjusting back to pre-QE levels.

Alternatively, if the ECB’s QE program shows early success in stimulating growth and inflation, yields could rise much sooner. Evidence of growth and inflation suggest the eventuality of yields rising above the inflation rate. Expect investors to anticipate such movement and avoid holding debt that may fall in price and rise in yield, even if the ECB has substantial purchasing power remaining in its QE program. 

Finally, circumstances in the United States also may help end negative yields on European debt. Stronger U.S. economic growth, combined with likely interest-rate increases from the U.S. Federal Reserve later this year, could attract investment flows from Europe. Whether these flows are enticed by a stronger U.S. equity market, continued strength in the U.S. dollar, or rising short-term interest rates, the exit from high priced European debt could pressure European yields higher long before the completion of the ECB’s QE program.

Conclusion 
The magnitude of the ECB’s purchases, relative to the available supply, seems capable of perpetuating negative yields throughout 2015 and into 2016. Just as the liquidity created by the Fed during its QE programs influenced other asset classes within and outside the United States, the spillover effect of the ECB’s program likely will affect U.S. debt by providing price support from global investors. The globalization of financial markets also influences U.S. debt prices by reducing the bond supply available to U.S. investors. 

Long-term consequences of negative yields, however, suggest this phenomenon will end. This may result in volatility, however, rather than a gradual adjustment. Global investors likely will react quickly to pockets of economic strength and inflation in Europe or in the United States, as they anticipate associated currency movements and central bank policies that could affect bond valuations. The distortions and consequences of negative yields could influence investment values for some time. But this phenomenon is not likely to be the "new normal," and its reversal likely will be characterized with volatility.

 

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