At Any Rate

Topics - Macroeconomics

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At Any Rate

Negative yielding bonds can be very challenging for marketers. It’s hard to come up with a pitch for a security which promises to lose money if you hold it to maturity. 1 1 Close It may be one case where past performance is indicative of future results. It's not much different from trying to make a commercial for an optional tax. 2 2 Close If you love getting money deducted from a paycheck, we have an investment for you! Yet even without a good slogan, negative yielding bonds have sold very well – there are around $12 trillion of them outstanding. 3 3 Close Source: Bloomberg as of December 4, 2019, $11.8 trillion of the Bloomberg Barclays Global Agg market value had a negative yield. This brings up an important question: why would anyone pay the government (or in some cases private companies) for the privilege of lending them money? Are these investors not paying attention to what they are buying?

One possible answer is that the buyers of negative yielding bonds are the governments themselves. Indeed, central banks have bought large quantities in both Europe and Japan for their QE programs. 4 4 Close Assuming you think central banks are government agencies. Central banks are often considered non-economic buyers, but they are not alone. Private investors own trillions of dollars worth of bonds with negative yields, and they are, in theory, concerned about the economics of what they buy. A cynic might say that the only reason these private investors are holding the bonds is to earn a quick buck as central banks push yields lower. A purely speculative market would probably be an unhealthy market, but this does not seem to be the case. While short term capital gains may be the motivation of some investors, there are a variety of other reasons for individuals and institutions to hold negative yielding bonds.

An investment can have desirable characteristics other than just its expected return. The main attraction of government bonds is their perceived safety. Many of the countries with negative yields are considered very unlikely to default and many have sovereign currencies. 5 5 Close Germany as part of the euro is an exception, but it is considered very safe. Institutions looking for safe places to put their cash have few alternatives. It is not realistic to place large cash balances in paper currency, and banks may present higher credit risk and may charge for balances. A fund or company may need the bonds as collateral for derivatives positions.

Negative yielding bonds appear to maintain many of the portfolio characteristics of positive yielding bonds. They can react in the same or similar manner when presented with economic data or political events. Investors who hold risky securities may look to them as a way of reducing volatility in their portfolios. Negative yielding bonds can also meet duration needs. A pension can still use the negative yielding bonds to match assets and liabilities, though they may increase its funding needs.

In other words, there are several types of investors who hold these bonds because they don’t have a better alternative. While the negative yields hurt, the benefits can still outweigh the costs. But not all buyers do so begrudgingly. Some folks may want negative yielding bonds for the most unlikely of reasons: their yield. Even though these bonds have negative yields, they can provide carry. Depending on the shape of the yield curve, the rolldown can be positive. A leveraged investor might be able to finance at an even more negative rate than the bonds and thereby earn the spread.

A lesser discussed fact is that foreign investors can have very different economics. 6 6 Close I know that sounds like a bad marketing slogan you might hear, but it’s true. Many investors want to get diversification in interest rate exposure for their portfolios by adding international bonds, but they don’t want to make currency bets. To mitigate this exposure, they hedge through FX forwards and cross currency basis swaps. These currency-hedged foreign bonds tend to earn around the same yield as the investors’ domestic bonds, assuming the credit of each country is equivalent. This is because they earn positive yield on the hedges, which is higher than the negative yield on the bond. In theory, a currency-hedged U.S. investor should earn around the same yield investing in German bunds or Japanese government bonds as they do in their U.S. Treasuries. 7 7 Close For those interested in a technical explanation as to why: If the currency-hedged yields were significantly different then investors would move their money to the higher yielding bonds. Say, for example, German investors could move their money to currency-hedged U.S. bonds and earn 3% more than their -50bp yielding bunds. They would all do that! That is why the FX forward markets should price Treasuries at the same yield as bunds – accounting for the currency hedge. A German investor of course can earn more yield on U.S. Treasuries, but would have to take the currency risk of holding dollars.

But this is not always the case. Sometimes capital flows or other circumstances can move the FX forward markets and create anomalies. Over the past few years, U.S. investors could earn higher yields on bonds in Japan and Germany than they do in the U.S., provided they hedge the currency exposure. This may be the result of investor preferences for international fixed income securities from those countries. The chart below illustrates this.

10 Year Bond Yields in a Hedged U S Investor's Portfolio

Source: AQR, Bloomberg. Yields as of December 4, 2019. For illustrative purposes only and not to be construed as investment advice.

This analysis doesn’t tell you anything about the direction of interest rates or whether non-traditional monetary policy is an effective economic tool. What it does tell you is that there are a variety of reasons that investors may want to hold negative-yielding securities. Many of the reasons can apply even if yields fall significantly lower than they are now. It is interesting how strong reactions have been to nominally negative bonds in recent years. In the past, real yields (adjusted for inflation) have been negative, and it went mostly unnoticed, but investors tend to think in nominal terms. It’s not false advertising to tell investors to look beyond what they see in a yield.

What We Are Watching

FOMC Meeting (Wednesday)
The FOMC will hold its final meeting of the year next week, and forecasters see practically no chance of a change in rates. The committee adopted more neutral guidance at the October meeting, as policymakers judged that the current level of the Fed Funds rate was appropriate to balance upside risks from a strong labor market and rising wages against downside risks stemming from trade developments and the global slowdown in manufacturing. On the latter point, the ISM manufacturing posted its fourth consecutive reading below “breakeven” this week, a development that may raise some concern in the committee. More reassuringly, household consumption has remained strong, as reflected in the Q3 GDP release. Market participants will be looking to see whether trends in data and/or recent developments in the U.S.-China trade dispute have impacted the committee’s view on the outlook. Any sign of increased concern around downside risks might lead to gains in fixed income and weakness in the dollar.

U.K. General Election (Thursday)
This week, the U.K. will hold a General Election to choose the 650 members of the House of Commons. Politicians and market participants are hoping that the election will provide greater clarity on the path forward for Brexit, which is set to occur at the end of January but still lacks a fully approved roadmap. Current opinion polls show Prime Minister Johnson’s Conservative Party with a sizeable lead over the Labour opposition. However, polling errors have been fairly large in some recent U.K. elections, and the country’s electoral system means that the distribution of votes across constituencies is important. Should the Conservatives win a large majority (as most polling models currently expect), Johnson will likely be able to pass his Withdrawal Agreement (WA), allowing Brexit to occur on schedule and negotiations over future trading arrangements to begin in earnest. Reduced uncertainty might boost the British pound and lead to modest weakness in U.K. fixed income. However, even a modest disappointment relative to polls might leave the Conservatives with a slim majority, potentially giving advocates of a “Hard Brexit” leverage to push for a sharper break with the EU. If Conservatives fall well short of current polls, a hung parliament might mean that the gridlock seen over the last year persists indefinitely. This could be the most negative outcome for market sentiment, as the risks of an eventual No Deal Brexit might revive.

European Central Bank Meeting (Thursday)
After the European Central Bank decided in September to cut its key policy rate to -0.50% and restart quantitative easing, expectations for imminent further monetary policy action have faded. However, with Mario Draghi stepping down at the end of October and Christine Lagarde stepping in as the new ECB President, expectations for a strategic review of the central bank’s mandate and policy tools have increased. Policy action is unlikely at this week’s meeting, but President Lagarde’s first post-meeting press conference will be watched closely. Lagarde is likely to be questioned on what a strategic review would entail and any hints around potential adjustments to the ECB’s inflation, financial stability or communication goals could be market moving.

This material has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and AQR Capital Management, LLC (“AQR”) to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. The information set forth herein has been provided to you as secondary information and should not be the primary source for any investment or allocation decision.


Past performance is not a guarantee of future performance.


This document is not research and should not be treated as research. This document does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR.


The views expressed reflect the current views as of the date hereof and neither the author nor AQR undertakes to advise you of any changes in the views expressed herein. It should not be assumed that the author or AQR will make investment recommendations in the future that are consistent with the views expressed herein, or use any or all of the techniques or methods of analysis described herein in managing client accounts. The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only.


The information in this document may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this document, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.