The surge of negative yielding global debt is a cycle-specific phenomenon that has generated a lot of discussion with our clients. Bloomberg originally began posting about it back in the early Summer, and since then, several pundits have used it as fodder for their time in front of the camera. Given the amount of bonds breaking the zero bound has caused a few of us to scratch our heads here on Lincoln Street, we felt it made sense to address the topic. More importantly, several clients had great questions about the topic that we wanted to address! Some of the highlights we’ll seek to answer include: how did the markets get here, what are some potential risks associated with a negative interest rate environment, and how does one allocate capital in this type of environment?

How did we get here?

There are several forces at work that have created the current situation, where nearly $14 trillion in bonds across the globe now trade at a negative yield[i]. The key relationship to keep in mind here is that when there is more demand for bonds than supply of bonds, yields will go down, prices will go up, and vice versa.

Over the last ten years, the demand for sovereign (and in some cases corporate) bonds has exploded on the back of central bank asset purchasing or “QE” (quantitative easing) programs. According to the team at Yardeni Research, at the end of 2018, the four largest central banks carried just under $20 trillion in assets on their balance sheets, compared to $6 trillion at the beginning of 2008[ii]! Central banks have purchased everything from sovereign to corporate debt, artificially pushing bond yields lower.

In addition to central bank demand, large institutions like pensions, banks and insurance companies are required to own bonds for liquidity or collateral purposes. So, despite the potential for a negative financial return, these institutions are another marginal buyer of bonds.

On top of the above structural factors augmenting lower yields, the bid for “safe” assets has helped to push bond yields lower. As a result of the litany of geopolitical uncertainties that have come to light throughout 2019 (trade war tensions and presidential impeachment inquiries to name a few) the prospect of buying a bond for protection of capital may still make sense despite the risk of a negative return on that capital. Just the other day Rick Reider, a well-known bond Portfolio Manager at Blackrock, mentioned he actively buys bonds with yields below zero because he believes those yields may move lower and bond prices will rise[iii].

What are some potential risks?

A key risk of negative interest rates is the potential for rapid inflation and asset bubbles. An artificially large amount of money in the markets should promote artificially high prices. Given the “punch bowl” has been refilled, spiked and moved to the center of the party, it may be fair to assume that we are currently in a period of artificially elevated asset prices. This could mean that returns in the future are either lower or negative if the support for higher prices goes away.

Another risk we have considered is the distortion of investor psyche and behavior when it comes to risk taking. How does a borrower rationalize the risk / reward tradeoff when they can get paid for taking on a mortgage in Denmark[iv]? If a country can borrow money for 100 years at 2.1% - what types of investments are they saying no to[v]? Does the 60/40 stock & bond investor expect to make the same 10% over the next ten years as they have in the previous ten[vi]? Our feeling is they probably shouldn’t.

Last, what happens when central banks stop their asset purchasing programs? While we would expect that they will do this tactfully across the globe, theoretically rates should go up along with the cost of capital. Equity markets would likely adjust to higher interest rates and credit spreads should widen. Businesses that are not sustainable in a higher borrowing rate environment would go out of business. This is not what you’d call an optimal scenario for the average investor!

How does one allocate in this type of environment?

Let’s agree that the recent time period has been unique. While negative yielding bonds are not completely unprecedented in this cycle, the absolute amount of negative yielding debt has not been seen before in history. Simultaneously, equity markets have continued to move higher, with the S&P 500 achieving record levels this past July[vii].

In this type of environment, the 60/40 stock & bond investor must be willing to accept that returns may be lower in portfolios. If they can’t, they must get comfortable employing a greater amount of risky assets to achieve their return targets. Should we still think of bonds as an instrument that protects our portfolio from a meaningful drawdown in equity markets? Sure, but we must accept that total returns will be lower given starting yields are so low. Can we still think of equities as return enhancing investments as we have before? Sure, but again we must taper our expectations given price levels are near record highs.

Although it is always an “interesting time” in the investment world…I think we will look back at this period as “a really interesting time”.

Sources:

[i] Franklin Templeton: Templeton Global Bond Update October 1, 2019

[ii] Yardeni Research, Inc. – Total Assets of Major Central Banks

[iii] NPR Morning Edition: “Who buys bonds with a Negative Interest Rate”

[iv] Confounded Interest: “The Reasonabilists: Negative Yielding Debt Exceeds $17 TRILLION…”

[v] JP Morgan – “Return of the Century Bond”

[vi] Research Affiliates Asset Allocation Interactive as of 08/31/2019 (60% US Stocks & 40% Bonds)

[vii] Market Watch: “The S&P 500 just hit a record high – so did these stocks”

Disclosures: The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor. The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur. All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. The information contained above is for illustrative purposes only. New World Advisors, LLC (“New World]”) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where New World and its representatives are properly licensed or exempt from licensure. Generally, among asset classes, stocks are more volatile than bonds or short-term instruments. Government bonds and corporate bonds have more moderate short-term price fluctuations than stocks but provide lower potential long-term returns. U.S. Treasury Bills maintain a stable value if held to maturity, but returns are generally only slightly above the inflation rate.

Questions Surrounding Negative Interest Rates...