By Maarten Ackerman, Advisory Partner and Investment Strategist, Citadel
We have previously spoken about the new phenomenon of negative interest rate bonds – those which are issued with a negative yield, meaning that the total interest and principle payments received from the issuer are less than the price of the bond at the time it was issued – i.e. the holder is guaranteed to lose money. But, interestingly, there is no shortage of buyers willing to purchase these bonds in which they are certain to see a capital loss at the time of maturity.
Bloomberg has reported a surge in demand for such bonds. As at 30 September, the total face value of negative-yielding investment-grade corporate and sovereign debt in the Bloomberg Barclays Global Aggregate Index jumped to $11.6 trillion, up 6.1% from end August and close to June’s $11.9 trillion peak. As an example, German company Henkel’s recent bond issue, which carried a negative redemption yield and raised half a billion Euros, was actually oversubscribed.
But this raises the obvious question – why would anyone, including highly respected investors and investment companies, be lining up to guarantee a loss for their portfolios?
Firstly, some of the primary buyers of negative rate bonds are central banks. Bond purchasing remains an important element of quantitative easing and this is merely an extension of that programme. Buying the fixed interest instruments puts liquidity into markets and keeps interest rates low. And the lower the interest rate, the greater the extent of the expansionary policy – thus, keeping the cost of capital low and removing the incentive to save in the hope that this will increase aggregate demand and stimulate economic growth. As bond purchasers, central banks increase the demand for them, thus putting further downward pressure on rates.
Secondly, many investors are forced buyers of bonds due to regulatory requirements and in order to adhere to mandate prescriptions. In some cases, investment in other asset classes is capped (for example Pension Fund Regulation 28 in South Africa limits equity investments to 75% of a fund and equities and property combined to 90%, compelling retirement funds to invest in interest-bearing securities). In other cases, funds may be required to hold a minimum amount in bonds or money market instruments to ensure that they are able to meet their liabilities and their capital adequacy requirements. This includes some major global pension funds, short and long-term insurance companies and medical aid schemes.
Each fund has a board of trustees which draws up an investment mandate for it and the fund managers are required to adhere to the mandate. In many instances, the portfolio policies (mandates) are based on asset-liability matching with bonds having historically been well suited to meeting retirement fund liabilities. It is, however, possible that these mandates are no longer appropriate, given this new negative interest rate environment. In this case, the funds would need to make a mandate U-turn to suit the upended environment. Trustees need to be interrogating their “old” definitions of asset class risk, redefining it and constructing new portfolio policies for the new era instead of just adhering to probably less efficient mandates and following yields lower as central bank buying continues.
However, changing a retirement or other fund’s portfolio policy is not something that normally happens overnight and can take months and even years in some circumstances. They are based on long-term studies of which there are none available for the uncharted territory of negative interest rates. To make matters worse, many funds are still underweight equities following the 2008/9 recession and market crash. Add to this the fact that there has been a major bond bull market and it’s easy to realise why these funds are still overweight bonds.
But there is another issue at play which may, in fact, see negative interest rate bonds being suitable for retirement portfolios. Deflation remains a real risk for many parts of the world as aggregate demand remains weak and fundamental structural headwinds, such as aging populations, keep inflation pressures absent. In a deflationary world, a pension fund’s liability as we understood it historically would easily swing 180°. With prices falling, pension pay-outs could decline and a retirement fund could find liabilities falling over time. Buying negative rate bonds would still result in assets matching liabilities and, if this were the case, there would be no need to alter portfolio policies.
Bonds are no longer the safe haven risk-free asset of yore. As the 35-year bull market comes to an end the risk-free nature will change swiftly into a return-free one. We would suggest that investors who can should switch out of bonds and into equities, notably high dividend yield companies. For discretionary investors, it is far better to own a company’s stock than to be invested in bonds. Most of these companies are flush with cash and still operate in an environment that can sustain dividend payments. Those investors who cannot stomach the volatility of equity investing could diversify into other alternative investments such as hedge funds and protected equity solutions instead of the traditional cash and bonds.