Article / 29 March 2015 at 23:27 GMT

Eurozone's negative yield vortex is enhancing risk

Managing Partner / Spotlight Group
United Kingdom
  • About €1.44 billion of Eurozone sovereign debt carries negative yields
  • Norway's Norges bank wealth fund has acquired Nigerian sovereign debt
  • Buyers should tread carefully when considering structured products

By Stephen Pope

If one looks at the structure on the average Eurozone sovereign yield curve as at close of play on Friday, one can see that one has to move out to longer than six years before one can pick up a positive return.

The quantitative easing programme of the ECB has driven one third of the entire Eurozone debt issuance which totals €5.8 trillion to carry a negative yield to maturity. For those that can hold paper with a negative yield, it is clear that they are simply riding the coattails of the QE programme in the hope that they can pass there securities onto another party before the bonds reach maturity.


Source: ECB. Create your own charts with SaxoTrader; click here to learn more.

However, many state and national investment funds are legally barred from investing in an debt asset that carries a negative yield. This means that investors are facing a serious dilemma as to where to place existing and new funds. The implication of that is a fund manager has to choose between with an allocation of capital to conventional debt instruments from “unusual” issuers or stray down the route of synthetic and structured products.

The largest sovereign wealth fund, Norway's Norges bank Investment Management has $863 billion under management (Source: sovereign wealth fund rankings). It indicated in February that it had started to acquire sovereign debt issued by Nigeria.


Frontier market debt involves risk, and war with Boko Haram is just one of the uncertainties facing developing nation Nigeria and its president, Goodluck Jonathon (left). Photo: iStock

The current five year debt issued by Nigeria due to mature on February 13, 2020 yields 16.500%. Of course in the contemporary yield environment, such a yield is only available from an instrument that just a matter of months ago may not have appeared on an investor's radar screen. Standard & Poor’s credit rating for Nigeria stands at BB-. Moody’s rating for Nigeria sovereign debt is Ba3. Fitch assigns a credit rating for Nigeria at BB-.

Moving from developed and even developing markets into realm of “frontier markets” naturally entails a greater risk to the investment principal. So once again the real growth area in the investment industry is compliance and risk management.

However, for many, the concept of paying sovereign nations for the privilege of owning their bonds is a non-starter, and yet frontier markets are too much of a leap into the unknown. Nigeria for example, the most heavily populated African nation, has been suffering a running battle with the Islamist extremists group Boko Haram, which seek to establish a separate Fundamentalist Islamic state in the north. Over this past weekend, the country has been trying to hold a delayed Presidential election. It did not get off to a good start as on Saturday when the country’s president, Goodluck Jonathan, was denied registration and officials had to hastily find a way for him to vote.

National television showed the President standing in a tented polling booth for 20 minutes in his home village of Otuoke in Bayelsa state. At least three card readers failed to accredit either his ID or that of his wife. The election had originally been due to take place on February 14 but was postponed, ostensibly for security reasons. Since then, Nigerian military and regional allies have made significant gains against Boko Haram in the country’s north-east. There are also fears of post-election violence, though leading candidates signed a peace pledge.

What about structured products?

The growth in the number and variety of investment products has persisted for years, and such innovative products make it possible for an investor to gain from any price or interest rate move in a specific underlying instrument. The underlying asset can be debt, equity, an index, currency or a commodity.

There are many arguments as to whether such investments in structured products are more risky than a commitment to conventional or plain vanilla products. I am mindful of the safety mechanisms or even capital-protection guarantees that can be built into such structures.  
However, they can equally be geared with knock out triggers or tiered “wedding cake” levels, which once activated take the investor into a lower return structure. As Long-Term Capital Management found out to their cost, it is not unknown for all the fates to align and so spread plague and pestilence.

More typically the difficulty for even the most sophisticated investors comes from the broad array of structured products on offer … and in understanding all the potential scenario consequences before picking the right instrument.

I mentioned “wedding cake” products that feed off leverage and as such are only suitable for investors who are ready, willing and able to bear risks. These products will display a skewed payoff matrix that is hallmarked by a response that is disproportionate to price moves in the underlying instrument.

Other typical instruments include Callable Yield Notes deliver yield enhancement, whose performance is capped by a coupon guaranteed by the issuer. The issuer, at its discretion, can call the product usually on predefined observation dates. The underlying assets are generally composed of several stocks or stock indices, thus making it a product based on a “worst-of” function.

Or consider, Double Currency Units/Notes are a form of short-term bonds with an embedded option allowing the issuer to redeem the bond including the coupon in an alternative currency. In compensation for taking that risk, the holder of a note is entitled a higher than normal coupon. So it is really nothing more than a short-term speculative play on the forex market in which the initial investment is redeemed in the currency that weakened against another.

The risks that are associated with structured products, especially those that present risks of loss of principal due to market movements, are similar to risks involved with options. Thus the serious risks demand that only well-established and market profession customers must be explicitly approved for options trading. The US Financial Industry Regulatory Authority (FINRA) suggests that firms establish whether purchasers of some or all structured products should be required to go through a similar approval process, so that only accounts approved for options trading would also be approved for some or all structured products.

Risk on the rise?

The problem with chasing yield through exposure to the frontier markets or structured products is that there must be a sacrifice in liquidity and price transparency. Can one always get a working bid that is available in good size? That requires there to be pool of at least five authorised market makers. But who has issued the authorisation?

A failing of structured products is that they rarely trade after issuance, and anyone looking to sell a structured product before maturity will have to sell it at a significant discount, that is, the capital is either completely locked up come hell or high water or one will face a bid-ask spread that one could drive a coach and horses through. The lack of daily pricing and transparent pricing is equally an issue as structured products tend to be priced on a matrix computation, not net asset value.

Devotees of structured products may cry foul, but matrix pricing is a quant programme derived best-guess approach to evaluating a highly complex return calculation. But as the first lesson in investment theory drills into each and every intake “Caveat Emptor”!

– Edited by Robert Ryan

Stephen Pope is the founder and managing director of Spotlight Ideas. Follow Stephen or post your comment below to engage with Saxo Bank's social trading platform.


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