The amount of money being pumped into negative yielding debt has soared in recent months, but Heartwood Investment Management’s David Absolon says that investors should be paid for taking risk.
The amount invest in bonds with negative yields has soared to $16trn more recently, fuelled by the extraordinary conditions of the post-crisis environment.
This is much higher, said Absolon, than the 2015-2016 period “when the world economy teetered on the brink of recession”.
“While the level of negative yielding debt is new, an environment of lower yields has existed for some time,” said the Heartwood investment director.
“Businesses have naturally been incentivised to take advantage of this environment to reduce the cost of servicing their debts, and many have been able to opportunistically extend the maturity of these debts at a time to suit them.”
Global negative yielding debt levels (US$trn)
Source: Bloomberg
The amount of negative yielding debt has risen for three main reasons, said Absolon.
The first is that central banks, in a bid to shore up the global economy, have been putting forward even more interest rate cuts, with the US Federal Reserve the most recent example. This has encouraged “extraordinarily low bond yields”.
In addition, there have also been hint of further accommodative central bank action, such as the European Central Bank, which is likely to delay any interest rate hikes.
The second reason, said Absolon, is that while certain drivers of global economic growth have been robust, weak economic data overall has dampened investor sentiment.
“Growing unease has led to a flight to safe have assets like government bonds, as continued fears around global growth push wary investors to preserve as much capital as possible at all costs,” he said.
Finally, the fall in inflation expectations and the likelihood of further falls means negative yielding debt looks relatively less risky.
One of the biggest contributors to the level of negative yielding corporate debt is Europe. While $1.1trn of a total of $1.6trn emanates from the financial sector the remainder the remainder is made up non-financials including 14 eurozone non-investment grade companies, such as Nokia.
“In places where cash itself offers a negative return – such as the Eurozone, where the European Central Bank has set negative interest rates in an effort to stimulate the stuttering economy – negative yielding bonds may appear less risky on a relative basis,” said Absolon.
“In Europe, positive yields are only available on 30-year+ bonds – in some countries – meaning that investors must take on substantial interest rate risk for still only minimal yield.”
Negative yielding European corporate debt levels (US $bn)
Source: Bloomberg
Whilst the existence of low bond yields have been seen across the world historically, Absolon said negative yielding debt is less common, particularly in the developed market space.
“Between Brexit, the 2018 US tax break sugar rush, and Europe’s decidedly shaky economy, yields in these regions have diverged materially,” he said.
“In the UK, where economic fundamentals are currently challenged given the fog of Brexit, yet where inflation expectations are fairly solid – in part due to a weakened currency – debt markets are still conducting themselves in a relatively orderly fashion.
“In Europe, where the central bank is keen to do more to stimulate economic activity, negative yielding debt is likely to increase in the short to medium term.
“This is because the European Central Bank itself will likely soon begin buying sovereign and corporate debt again, pushing yields even further into negative territory.”
However, Absolon was quick to note that not all debt in Europe is being issued with negative yields.
“Notably, asset-backed securities in the region are offering positive yields, and yields on eurozone financial corporate debt are also comparatively high, with banks compensating investors for taking on higher credit risk,” he added.
Heartwood’s Absolon said the situation could potentially deteriorate if central banks were to cut interest rates further and enact more quantative easing, creating more negative yielding debt.
In fact, Absolon said negative yielding debt is likely here to stay although level could fall off quite dramatically.
“Good news on US-China trading relations, for example, would likely provide an instant relief for the global economy, offering encouragement to nervous investors and comfort to anxious central banks,” he explained.
Nevertheless, Absolon said that investors should be rewarded for taking some risk in the market.
“Investors who believe that long-term yields will continue to fall may see negative yielding debt as a case of ‘better the devil you know’,” he said.
“But given that bond yields are intended to compensate investors for the risks they take in lending out their capital, in buying negative yielding debt, investors are effectively pricing in no credit risk – the risk that the borrower defaults – or interest rate risk – the risk that changing interest rates reduce the relative value of the bond – for the duration of the bond they are buying.”
Absolon added: “Time will tell whether or not this was a wise assumption.”
He concluded: “While bonds are relatively low risk investments compared to stocks or alternative assets, no investment can ever be risk-free, and we think investors should always be compensated for the level of risk they take on, given the underlying economic backdrop.”