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Investing In Government Bonds: Low yields, high interest

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The euro-zone sovereign debt market is distorted by negative yields and quantative easing. Joseph Mariathasan assesses solutions to the situation 

At a glance

• Negative yields look like they are here to stay for a while.
• Conflicts between central bankers, regulators and politicians explain the dysfunctional character of the capital markets.
• Financial institutions of different types are having to adapt to the low-yield environment.
• A return to normality ultimately depends on political action.

“Over 40% of the euro-zone government bond market is in negative territory. In Japan it is 70%. It’s not over yet in Europe,” says Vincent Reinhart, chief economist at Standish Mellon. 

What is more troubling is that the current environment may represent a better alternative to what could have happened. “Imagine that the ECB [European Central Bank] did not act in the way it did by lowering yields and buying government bonds,” says Marie-Anne Allier, head of euro fixed income at Amundi Asset Management. “Current yields may not have been negative, but it is likely that by 2011 the euro-zone would have broken down and we would be having enormous problems relating to solvency and the sustainability of government debt.” She adds that the problems for banks and insurance companies would have been worse than today’s problems over negative yields. Yet euro-zone investors still face challenges in a dystopian parody of how free markets work.

Until about 18 months ago, the idea of negative yields was taboo, going against all financial theory. When they first arrived it was assumed to be a temporary phenomenon but it is has lasted longer than anyone imagined. Cosimo Marasciulo, head of european government bonds at Pioneer Investments, says: “Originally, the thinking was that central banks would manage to push inflation higher, there would be a higher inflation premium at the long end of the yield curves and there would be some normalisation of interest rates. But the reality has been very different as central banks cut rates further into negative territory. The story is about an overpricing of whole yield curves.”

The euro-zone, like most advanced economies, is challenged by demographics and low productivity. These suggests that yields will be low for a long time. If on top of that the ECB is buying more fixed income assets there will be further downward pressure on yields. That pressure is substantial. 

Generali Investments estimates that there will be an average reduction of outstanding euro-zone sovereign debt of €50bn per month. This takes into account issuance by national treasuries whilst subtracting redemptions and coupons paid, combined with the debt bought by the ECB.

“In April, it was around €100bn. In 2016, the ECB is clearly buying more than the governments can issue. This creates distortions in the market, and this is why, since the beginning of the QE [quantitative easing] programme, yields have gone down so much, with the 10-year Bund now yielding only 20bp” says Eric Domergue, head of fixed income for Generali’s third-party business. 

Reinhart says, the chances are the ECB will have to continue large monetary easing purchases for a while, which will put downward pressure on yields for some time. 

What underlies much of the bizarre feel to the euro-zone is the conflicts between the main players. The bad news, points out Reinhart, is that it is by political design. Over the years, politicians have created different agencies and given those agencies different missions and different time frames. 

Central banks tend to interpret their mandates narrowly. For the ECB and the Bank of Japan, it is targeting inflation. For the Federal Reserve, it is a dual mandate of creating maximum employment and stable prices but all central banks have a precise mandate focused on economic stabilisation. 

So the job of a central banker in this environment is to put the accelerator to the floor to meet their objectives. The mission has a short to medium term focus. Bank regulators, by contrast, are worried about the infrastructure to support banking over the medium to longer term and so negative rates are a prime example of conflict. Regulators who want banks to be recapitalised do not want them to be taxed immediately by paying to hold central bank deposits. 

Cosimo Marasciulo & Marie-Anne Allier

Reinhart adds that it is hard to know what politicians want to do, but to the extent that they have a backup of concerns over fiscal stability they have a medium to longer term focus. The result is a regulatory environment forcing financial companies to hold more government debt while the central bank is encouraging investment in riskier assets. 

Banks and insurance companies will have to adapt to the low yield environment. “It is more of a problem for insurance companies than banks or pension funds as they are prevented by solvency rules from investing outside of fixed income,” says Amundi’s Allier. “For banks, the ECB has allowed them to borrow at zero cost which will help them by allowing them to lend at very low rates profitably with a margin. But insurance companies have to adapt their business model quite drastically.”

Property and casualty insurers will not face a problem as they will just increase the premiums they charge to reflect the reality of negative yields. However, continental European life insurers have no choice but to move away from guaranteed return products on their own balance sheets towards selling investment products in a UCITs wrapper. “Insurance clients are encouraged to invest in riskier products such as equities but they bear the market risk,” she says. “For pension funds it is the same. We are seeing pension funds diversify into real assets such as property, infrastructure, private debt, even emerging markets and the US to try and find more yield.” 

Fixed income managers are looking to riskier assets in the search for yield. One alternative is European investment grade credit where a key factor is the ECB decision in March to start an investment grade corporate credit buying programme. European countries at the periphery are the obvious next step away from the negative yielding euro-zone sovereign bonds. 

Opinions on the merits of different countries, do differ substantially. “We favour Italy and Spain, although in Spain there are some political uncertainties with the elections in June. At the current levels of spreads, yields of the Italian debt could go much lower if we compare it to German yields. The current pick-up for the 10-year bond, at around 125 basis points, should compress given the need for yield,” says Generali’s Domergue.

Robert Michele & Eric Domergue

In contrast, the French asset manager Carmignac is less keen on Italian sovereign debt. “In view of the current issues with the Italian banking industry weakness as well as the fact that Italian yields have reached fair value at below 1.3% for the 10-year we believe there is no further opportunity today in Italian long-term bonds. Should valuations change, and yields rise, there may be new opportunities to re-enter the Italian BTP [government bond] market,” says Sandra Crowl, a member of Carmignac’s investment committee. 

Instead Carmignac favours Spanish, Portuguese, Greek and Irish debt. “We anticipate further spread compression in these countries,” says Crowl. “In Portugal and Greece’s case we believe that yields are not trading at their fair value and could fall lower under ECB support and better fundamentals that both countries can afford in the future. We believe the political risks present will be resolved throughout the rest of this year”. 

Is there a way back to a more normal environment? Bob Michele, head of global fixed income at JP Morgan Asset Management, argues that the ECB is reaching the end of what it can do. “Monetary policy is reaching terminal velocity. They are opening the door to fiscal stimulus by sovereigns that can actually move forward. Germany in particular, is a powerful industrial economy, a big export engine operating with a currency at an enormous discount to what the Deutschmark would have been trading at.” 

Allier agrees. “At the end of the day, it is not a monetary question, it is a political question. The ECB is only buying time for politicians to undertake structural reforms to increase potential growth.” But, she adds, if we only rely on central banks, and there is no action politically or fiscally to stimulate growth, there will probably be no return to normal conditions for a long time.

“Maybe for my children, normality may be negative yields and zero growth and zero inflation whilst abnormality may be seen to be growth and inflation,” she says. Such a dystopian parody of capitalism is unlikely to provide a stable economic or political environment. That is ironic given the driving force for the construction of the EU was the utopian vision of a stable European political union. 

Readers' comments (2)

  • I don’t believe long term rates in the euro area will stay so low for an extended period of time. Monetary policy shouldn’t be meant to create growth but to restore growth and confidence to the extent that people are afraid to behave the way they normally would. To me , when central banks intervene in markets to such a large degree as they have since the financial crisis , they distort normal market signals in capital allocation : investing everyday in HY bonds of the euro area , I see that risk-reward correlation has completely broken out. Nowadays BB rating asset class yields from 2.05% to 2.10% in a 7year duration …! But keeping nominal rates too low for too long has some bad effects: 1) it makes market participants complacent about the future , because they believe that central banks will continue to intervene in the markets, and that encourages risk-taking behavior and creates financial bubbles ( for example in the credit markets as I mentioned before ). 2) keeping real rates too low for too long incentivizes increasing savings ( consumers do not buy goods today, waiting for lower prices tomorrow ) and maintaining low factory orders , which further create deflationary pressure. 3) Finally, the historic central bank policies create their own systemic risk because lower long-term yields extend the duration of long-maturity assets , keeping duration risk in the investor's portfolios extremely high . This last issue is strictly correlated with “liquidity” issue: when long term rates will go up , there will be a “on-side market “ . All sellers , no buyers . This leads to huge asset price distortions, because governative bonds are benchmarks, they are the bedrock upon which we price everything else, whether it’s discount rates for pension liabilities or equities

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  • Let's talk about credit markets now. We currently have more than $7 trillion of sovereign debt at negative yields. That induces the stretch for yield . We now have firms that are in an unsustainable situation as their dividend yields are higher than their coupon yield.
    This is creating systemic risk, because leverage is increasing not only with sovereign debt but in the corporate sector as well. But, in the same time, there is not positive revenue growth except for developed Asia. The fundamentals don’t look good for companies because consumption isn’t as strong as it should be. That build-up in leverage has been accompanied by a decline in credit quality. What will happen when long term rates will go up and corporates will have to roll-over their bonds at higher costs?

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