- The German yield curve offers negative yields out to 9 years
- Standard bond models cannot cope with zero yield, let alone negative returns
- Corporations are holding an increasing amount of cash
- Businesses are using bond debt, not loans to finance expansion
You must now pay for the privilege of lending Germany money. Photo: iStock
By Stephen Pope
Across the Eurozone nominal yields on government debt in several countries have fallen close to their zero lower bound (ZLB). Indeed, parts of the yield curve are carrying a negative yield.
A serious issue has arisen as to how bond analysts can construct sensible models to capture the term structure of bond yields when some of those yields are zero or lower. It is a serious issue for bond portfolio pricing and risk management as well as for macroeconomic and monetary policy analysis.
Source: www.investing.com, Spotlight Ideas
The key empirical question that confronts financial market analysts is how to use negative and zero term yields to extract sensible market-based measures of expectations for future monetary policy and economic activity.
Rejecting the standard model
The standard model, so commonly taught in finance classes, is an Affine term structure that relates zero-coupon bond prices or the discount curve to a spot rate model. It is particularly useful for deriving the yield curve from observable bond market data. However, it ignores the ZLB and focuses on placing positive probabilities on negative interest rates.
The standard model becomes counterfactual when it embraces ZLB and negative rates as it overlooks the existence of a readily available currency for holding as well transaction purposes. In an environment of negative yields, it would appear intuitive that an investor always has the option of holding cash, and the zero nominal yield of cash will be regarded as superior, for passive investors, in contrast to any security with a negative yield. I believe that to be the case even in terms of the super liquid German 2-year that closed on June 13 at -0.526%.
The great distortion
As the first table revealed there are many areas within the Eurozone that features negative interest yields. Other European but non Eurozone markets with the same aspect are Denmark and Sweden to 5 years and Switzerland to 20 years!
There are potentially serious problems that arise from such a skewed series of yield curves and it may come to pass that central banks are only now realising that they may have to establish a floor as to how negative they can allow their rates to go. I am having to rethink my approach to monetary policy.
The impact of negative rates and hence bond yields which gets greater each day as new waves of quantitative easing is undertaken has now spread into the corporate debt environment and has seriously opened the issue of bond holdings being replaced by “cash under the mattress”.
In Germany, Munich Re has done just this as it seeks to avoid effectively paying the government for the privilege of holding Bündes debt or financing its agency banks for parking kits cash deposits at the European Central Bank at a negative deposit rate of -0.40%.
The German group said in March it would store at least €10 Million in two currencies so it won’t have to pay for the right to access the money at short notice.
Chief Executive Officer Nikolaus von Bomhard said in Munich on Wednesday, March 16:
“ …We will also observe what others are doing to avoid paying negative interest rates …”
Christoph Kaserer, Professor of Finance at the Technische Universitaet in Munich said:
“ …This may well become a mass phenomenon once interest rates are low enough, the only question will be where that exact point is? …For large institutions, that may be the case sooner rather than later. The ECB will react with countermeasures, such as limiting cash. …”
That later point might well prove difficult as the institutional investors are not playing a “hot money” or “speculative” game. They are seeking ways to make the best use of their money.
If such a strategy were widely adopted by other institutions could undermine the ECB’s policy (which I argued for) of imposing a negative deposit rate to push down market credit costs and spur lending.
Cash hoarding threatens to disrupt the transmission of that policy to the real economy, although as the chart above indicates the level of bank lending to the private sector has been flat since 2008. This shows the difficulties that the ECB is facing in its efforts to stimulate the real economy. Charging negative rates on overnight liquidity has not stimulated longer-term lending. All it does is make companies’ and institutions’ payment transactions more expensive.
Keep cash, with low rate use debt financing
Another consequence of rates and yields tending toward zero, or lower is that European corporations have sought to boost cash balances by using low cost debt as a means by which to finance strategic investment plans.
This is not a sudden phenomenon as on July 6 2015 the “Financial Times” reported that the senior vice-president at Moody’s Investor Services, Jean-Michel Carayon said:
“…Companies are finding it more attractive to finance their deals through debt rather than using their cash, due to abundant liquidity and low interest rates, …”
Of course, for certain corporations there may be specific reasons e.g. BP has retained a large level of cash following the 2010 Deepwater Horizon disaster. The total bill for this incident has reached $54 billion with several clams still to be addressed.
However, what strategic investment plans. In the European Union, much strategic investment has been delayed until it is known if the UK will stay or leave the bloc. Similarly, inside the Eurozone the prospect of the corporate debt being included in the ECB’s asset purchase programme has meant companies are increasingly issuing euro-denominated debt to fund share buybacks. In an attempt to bolster market share debt is also being raised to finance M&A.
One could fairly claim that current corporate strategy is not designed to create better products or reduce average cost by adopting more efficient processes. Rather it is targeted towards accumulating the competition and so build monopoly power. That will not necessarily translate to an improvement in consumer welfare.
Central banks in major developed economies have accumulated $10 trillion in government bonds since 2004, and currently demand approximately $3 trillion more a year cf. net annual issuance of government bonds of about $2.5 trillion. Indeed, such is the emphasis on deducing debt to GDP levels that the issuance total is still in decline.
This demand mismatch clearly is a key driver behind the fact that there in excess of $7 trillion of government bonds now offer yields below zero. This means that approximately 30% of a developed world bond index investors need to replicate has to be constructed around assets that are trapped in a negative yield environment.
For now, investors should pay close attention to the signals from policy makers, economic data, and anecdotes from other participants to create a flexible framework for investing in a world of negative yields.
At the most simplistic level we might assume that negative yields were just a result of a proactive monetary policy designed to stimulate economic activity on both the demand and supply side of the macro model.
As we have seen within the Eurozone it is entirely possible for the central bank to implement a negative short-term deposit rates in concert with central bank asset purchases of sovereign fixed income assets to drive bonds of increasing duration towards negative yields. This has encouraged speculative buyers as well to the extent that even the German 10-year is flirting with the zero bound closing last night at 0.024%. [Editor's note: Shortly after 0830 GMT this morning, the 10-yr bund yield did indeed hit an historic low of minus 0.01%]
As the ECB has announced an intention to acquire corporate debt the drive for investors to seek any yields advantage has started the corporate debt universe on a lower yield trajectory as well; policy-makers, in fact, hope that this development will drive investors out of “safer” government bonds into other riskier assets.
For example, the A+/A3 rated BHP Billiton Finance 3.250% 09/2027 now yields just 1.59% down from 1.78% i.e. lower by 19 basis points in the past month, and from 1.93% at the end of April.
The spread over the German 10-year benchmark has tightened from +166 basis points at the end of April to just +157 basis points at the end of trading last week. In this example, corporate debt has outperformed the best sovereign debt in Euro by 1.5 basis points a week.
The Fitch rating agency estimates that approximately 6% of outstanding European non-financial corporate bonds carry negative yields, equal to €170 billion.
So, in place of an Affine term structure the way to manage the curiosity of near-zero, zero or indeed negative yields is to use a shadow-rate. This can be achieved with the arbitrage-free Nelson-Siegel (AFNS) model.
This accommodates variables with a regular Gaussian or Normal Distribution but in addition the short rate is given an interpretation of a shadow rate so as to account for the effect on bond pricing from the existence of the option to hold currency. Therefore, we can model the market expectation even beyond the ZLB.
Bad times to come?
The negative yield structure could potentially be a herald that is forecasting a sharp economic slowdown. This could lead to an increase in corporate and sovereign defaults in the not so distant future.
If the low or negative yields are truly a warning of a deep recession, then it would be better to be acquiring the least risky asset and look beyond the superficial level of the yield to maturity. I say this as the yield and the total return if one uses a duration play will deliver a net positive. Why else would the Japanese Government Bond (JGB) market be one of the best performers on a risk-adjusted basis over the last decade even when impeded by persistently low yields?
Even with the benefit of the AFNS model seeking an over allocation of corporate debt in place of sovereign exposure may carry the risk of an enhanced tracking error to the designated benchmark. This has the potential to fuel potential under-performance versus the competition.
The dilemma is one could argue that to many bond indices have allowed sovereign debt to increase their weighting and so the so-called benchmarks are by default delivering lower absolute returns because of a larger portfolio component producing a negative return.
The rush to buy debt of either longer duration sovereigns or weaker, i.e. corporate credit means there is a diminished liquid pool of debt that can be used to match indices.
As a consequence, investors must either accept this cost in order to manage risk versus their benchmarks or abandon their benchmark and seek ever more exotic, complex, synthetic and illiquid products.
We do not need to watch “The Big Short” to recall how chasing opaque, structured products worked out.
– Edited by Clare MacCarthy
Stephen Pope is managing partner at Spotlight Ideas