Bond yields are low. Low compared to both their long- and short-term levels, low across various maturities and low around the globe. Some are even negative: while investors have traditionally regarded bonds as “fixed income” investments, in some cases they are now having to get used to “fixed expense” investing.
Just who buys negative-yielding bonds? What is the incentive? In this article, we outline four reasons why we think fixed expense investing may not be as strange as it sounds.
Clear Macroeconomic Trends Have Been Pushing Yields Down
Bond yields have been generally declining since the early 1980s, as would be expected given diminished real economic growth and inflation expectations. It’s a complex and controversial subject, but lower productivity growth, aging populations, the globalization of labor forces and supply chains, free-market ideology and inefficient utilization of capital due to inequality and geopolitical uncertainty could all be cited to explain this environment.
To justify a meaningful recovery in bond yields beyond what is already priced into upwardly sloping curves, we would need not just a stabilization of these trends, but a reversal. We see few signs of that. Central banks and governments have taken extraordinary actions against these trends since the 2008 global financial crisis, but have failed to spur a material improvement in growth. The potential for greater trade friction, curbs on immigration and “digital iron curtains” might be inflationary, but such factors are more likely, in our view, to depress growth.
Without an unforeseen macroeconomic catalyst, we believe that low yields are likely here to stay.
There Is Still a Duration Premium, Even in Negative Yield Curves
Negative-yielding bonds guarantee a “fixed expense” only if you hold them to maturity. But what if you maintain a constant maturity in your portfolio by selling your 10-year bond after a year, when it has become a nine-year bond, and use the proceeds to buy a new 10-year bond? This is called “rolling” a bond, and is said to generate “roll-down return.”
Imagine a negative-yielding, but upward-sloping yield curve. Now imagine a year going by, during which the yield curve doesn’t move. The 10-year bond you bought is now a nine-year bond, which means it trades at a nine-year yield—which is lower than the 10-year yield, because the curve hasn’t changed. You can sell that bond at the higher price and buy a new 10-year bond at the lower price, making a profit regardless of whether yield-to-maturity is positive or negative.
We’ve applied this simple logic to Germany’s yield curve, which is negative out to 30 years, but upward-sloping. If we take the difference between the three-month and 10-year yields (the return from exchanging cash for a 10-year bond for a decade) and add it to the difference between the 10-year and nine-year yields multiplied by 10 (the return from rolling that bond once a year, 10 times), we get a current expected return of 85 basis points for the next 10 years. Even when the curve was at its flattest, in August of 2019, the expected return was 48 basis points. The 10-year Bund yield is currently around -30 basis points.
Foreign Currency Hedges Can Supplement Low Yields
Investors often hedge out currency exposures from their bond allocations. That involves selling the foreign currency to buy the home currency, which means paying the short-term financing rate associated with the foreign currency and receiving the short-term financing rate associated with the home currency.
The tighter monetary policy that the U.S. has had in place relative to other major developed markets over the past three years has resulted in a higher financing rate for the U.S. dollar. Therefore, when most non-U.S. investors buy U.S. bonds with a currency hedge, they pay more to sell the dollar than they receive to hold their home currency. U.S. investors, on the other hand, receive a net benefit from currency-hedging their non-U.S. bond exposures. Since 2017, that benefit has amounted to two to three percentage points of extra return—enough to turn negative yields positive.
Negative-Yielding Bonds Can Still Provide Diversification
Risk-aware investors often seek diversifying assets that exhibit negative correlation with equity markets. Core, high-quality sovereign bonds are among these assets: the average correlation between German Bunds and German stocks, during recent years of very low and negative yields, has been -0.50. Many investors are willing to pay a certain premium for that diversification.
We believe this diversification argument is powerful but not appreciated enough by most investors. We can illustrate it with a simple example involving a negative-yielding asset. Imagine two assets, a stock and a bond, and two potential market environments, bull and bear. In the bull market, the stock doubles in value (i.e. 100% return) and the bond loses 60%; in bear market, the stock loses 40% and the bond doubles in value. Assume that both markets are equally likely to occur and are consequent.
Using this example, we know for sure that we will make money over time with the stock but lose money over time with the bond. So why allocate to the bond? The answer becomes clear when you put the two assets together into a 50/50 portfolio and rebalance it after each cycle. Within five cycles, this portfolio outperforms both the stock-only and the bond-only investment, as each asset class reduces the drawdown of the other to enable smoother long-term compounding of returns.
Even Negative-returning Asset Classes Can Enhance Long-term Portfolio Returns
Source: Neuberger Berman. The chart shows two assets in two different market environments, and a 50/50 portfolio of the two assets: in the bull market, the stock doubles in value and the bond loses 60%; in bear market, the stock loses 40% and the bond doubles in value; both market environments are equally likely to occur and are consequent. For illustrative purposes only.
Just how negative a return can we tolerate in exchange for this diversification benefit? That depends on how much diversification benefit a bond is likely to deliver. If a stock has an average Sharpe ratio of 0.40 and a -0.50 correlation with a bond whose volatility is 5% annualized, the minimum expected excess return necessary to justify including the bond in the portfolio is -1%. Bonds-at-any-cost may not be a viable investment policy, then, but the lower the correlation, the lower the minimum necessary expected return can be.
Allocations to Bonds Are Still Justified
Negative yields are not ideal—they are counterintuitive, unfair to savers and create mounting concerns for institutions with future liabilities. They may well be justified by economic fundamentals, however, and we believe drastic shifts in these fundamentals are unlikely and difficult to predict. With this in mind, we believe allocations to bonds, even some of those with negative yields, are still justifiable—as long as those low or negative yields are satisfactorily offset by roll-down return, currency-hedging return or diversification benefits.
