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Debtors’ Prison to Debtors’ Paradise?

| October 01, 2016
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Although I’ve written about negative bond yields in the past, I want to revisit the subject after recently reading a couple of interesting articles. According to various estimates, there is approximately $12 to $13 trillion of global debt with negative yields to maturity. A significant portion of this debt is comprised of European sovereign bonds which have seen yields collapse as the European Central Bank (ECB) continues to execute a massive bond-buying program. The ECB has reduced deposit rates to below zero and is currently purchasing 80 billion Euro per month of bonds. Earlier this summer, the ECB began purchasing corporate debt for the first time whereas it purchased sovereign debt in the past. Since the ECB began buying corporate bonds, several issues of corporate debt have joined the negative yield club.

A recent article in the Wall Street Journal points out how French drug maker Sanofi and German consumer-products company Henkel sold bonds that pay no interest at a premium to face value. In other words, investors paid slightly more for the bonds than they will receive when the bonds mature in a few years and they will receive no interest in the interim. This is like someone investing $1,000 in a five-year certificate-of-deposit (CD) at the local bank, receiving no interest, and only getting back $995 when the CD matures!

For companies fortunate to participate in this inexplicable borrowing arrangement, they essentially receive free money at the expense of investors who are guaranteed a loss, both nominal and real, if they hold the bonds until maturity. Given this bizarre scenario, why wouldn’t an investment-grade European corporation issue as much debt as possible when it has to pay back less than it borrows? Supposedly the ECB’s rationale for the bond purchases has been to lower interest rates to encourage banks to lend and companies to borrow and invest in order to spur economic growth. However, interest rates for investment-grade borrowers have been very low for a long time and it seems that at this point, the negative impacts of this extreme rate policy outweigh the benefits of any incremental borrowing.

It is inexplicable to me why anyone would freely choose to purchase a negative yielding bond with the intent to hold it until maturity, yet such bonds change hands daily. A recent article on CNBC’s website quoted Rick Rieder, BlackRock’s chief investment officer, about why BlackRock has purchased negative yielding bonds. Rieder explained, “The only reason you buy negative-rate bonds is if you think it’s going to go more negative.” Sure, if an investor buys a negative yielding bond and is able to sell it at an even lower yield, that results in a profit, but isn’t that the definition of speculation, not to mention a very risky proposition? What if you get stuck with it? To me, this sounds like flipping internet stocks in 2000 and houses in 2006. Of course, the big difference now is that investors are guaranteed that the ECB will be purchasing these bonds in the market. The ECB has announced how much it will spend and for how long.

The same CNBC article goes on to quote John Bredemus, Vice President at Allianz Investment Management, “People don’t want to hold negative yielding bonds. They just want to make a profit." Again, this sounds like the “greater fool” theory and has no benefit to the real economy. It seems that the ECB’s bond buying program is a great way to line the pockets of speculators and boost asset prices but I doubt it will do much to spur productive lending and revive the European economy. Someone has to be holding these bonds when they mature and someone must suffer the loss.

While negative rates might make for great trading opportunities, what about savers and investors who depend on interest to fund liabilities? We know that traders and speculators buy and sell negative yielding debt trying to make a profit but what about those institutions that are mandated to own investment grade bonds? If a mutual fund has a mandate to own long-dated sovereign German bonds, then the manager of that fund has no choice but to own those bonds. Many institutional investors such as pension funds, insurance companies, and financial institutions are governed by regulations that dictate the purchase of sovereign and/or investment grade bonds, and for these investors, negative yields are extremely detrimental to their long-term financial health.

Imagine a pension fund that must make payments to a pensioner ten years from now. How can this liability possibly be funded when the asset the pension fund would normally purchase (i.e. a 10-year German bond) has a negative yield to maturity? The math simply doesn’t add up. Consider a retired person living off their savings. If this individual’s interest income is 50% or less today compared to what it was several years ago, what else can this person do other than spend less or go back to work if they don’t want to exhaust their savings or take more risk than they otherwise would in a reach for yield? Increasing saving and reducing spending makes sense for someone in this scenario, yet this behavior produces the opposite of the economic growth the ECB is trying to stimulate. I don’t know how all this plays out, but I don’t see how it possibly ends well. The ECB is encouraging and rewarding speculators at the expense of savers and investors and turning the financial system upside down in the process.

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