[17]
Now that 2-year government debt carries a negative yield in no less than nine European countries, the trend is spreading towards investment-grade corporate bonds (with at least a BBB- credit rating).
The actions of the ECB – the quantitative easing – have made people anxious in their search for returns on the market and some investors are jumping in blindly, taking risks that often do not match their investment risk profile.
Just a year ago, investors who no longer found refuge in the low yields on German or Dutch government bonds could still turn to qualitative corporate bonds; these still offered an attractive spread at the time versus government bonds.
But lately something strange is happening in Europe. A whole range of bonds, especially government bonds from countries like Denmark, Switzerland, and Germany, now have negative yields.
- Finland was the first country in the Eurozone to sell debt at negative yield.
- Germany and Denmark have negative yields on bonds with maturities up to six years.
- In Switzerland you have to wait 14 years to see a (very small) positive yield.
- Even Slovakia is now selling short-term debt at negative yields.
It does not get much crazier than that …
No sense
According to JP Morgan, 1,500 billion euros worth of bonds will mature in over a year with a negative yield. Countries with less favorable credit ratings have also seen their yields drop spectacularly.
A country like Ireland, for example, that was practically broke a few years ago, is now issuing bonds that carry a yield of no more than 2%! At first sight this does not make sense. Why would you lend 100 euros only to get back less in return?
This seemingly goes against every economic theory book that states that inflation devalues money in the future and that investors should demand compensation based on their current inflation expectations.
Nevertheless, investors are acting based on (admittedly twisted) economic logic. Consumer prices in the Eurozone are namely falling by about 0.6% per year and Europe is still stuck in a very deep swamp, economically speaking.
You lose money if you invest in bonds that have a negative yield, but you are still outperforming your good ol’ savings account. Bonds are not just an investment, they also provide security for banks, hedge funds, and other parties on the financial markets.
They need these bonds for so-called repos, which is where you sell a bond for cash and promise to buy it back later with interest. That is very important and not only because the repo market is enormous.
Not Enough Bonds
Look at it this way: if you can turn a very safe bond into cash whenever you want, the bond becomes a very liquid asset. That makes that people will want to pay more for it, which pushes yields down even more.
There has always been some sort of a premium attached to qualitative government bonds, specifically for that reason. Today everyone is throwing themselves onto bonds because of the aforementioned logic, but also because there aren’t enough bonds available.
The strong budget cuts in Europe have strongly contained the amount of government bonds that can be issued, in order to minimize budget deficits, and the QE measures of the ECB are going to suck all of this debt out of the market now.
Banks that need government bonds will now need to look for alternatives: high-rated bonds from the most well-known and strongest companies. This brings us to Nestlé, the Swiss multi-national corporation known for its tasty cookies and other retail products…
The company is active in practically every corner of the world and has an incredibly strong balance sheet, which translates into an Aa2 credit rating. For the first time in history, the yield for a corporate bond of a company in the Eurozone turned negative.
Nestlé namely issued 500 million euros worth of 2016 bonds with a yield of … -0.002%. Never before have we seen something like this in our 20 years on the financial markets.
[17]
Source: Confounded Interest [18] [18]
The yields on Nestlé bonds with a longer maturity are also not very inspiring: bonds that mature in 2021 only have a yield of 0.33%. Nestlé is not the only company that is selling bonds with these yields, by the way (check the table below for reference). A year ago, you at least got something.
Race to the bottom
If companies and governments in the Eurozone will continue to sell bonds at these yields, the bond market will start to shrink once the ECB starts buying in March. The purchases of the ECB will outweigh what will be on offer month over month.
[17]Source: RBS, Bloomberg
This is a race to the bottom considering the fact that the spreads on corporate bonds are narrowing. The corporate bond market is thus now also seeing yields go down and spreads get increasingly narrow.
This will push investors to take more and more risks for the same return, which puts them in a position where they will not be able to correctly judge their investments; all because of the aggressive policies of the ECB. This is a dangerous situation that can lead to accidents in an investment portfolio.
Be aware of the above and keep your eyes open. Those with enough cash and gold in their portfolio will be well-protected. Pay attention to fixed income investments with negative yields, low liquidity or maturity dates that are far in the future. Inflation is a phenomenon that can pop its head up unexpectedly and do serious damage in one-sided portfolios.
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