Negative bond yields: a perspective
Market prices with a lack of liquidity can lead to the wrong conclusion
I recently read an article in the AFR by an esteemed author (who shall remain nameless) expressing dismay that 40% of the world's government bonds (on that day) were trading at negative interest rates. The article inferred incredulity that so many people were prepared to pay governments for the privilege of lending to them!
Whilst only serving to increase my reducing opinion of the quality of financial commentators that exist today, it also highlighted something that has been floating in my subconscious for some time.
That is, the most people really don’t understand how market prices work, and or more importantly what they represent.
The key thing that bothered me about this article is that it failed to point out that bond trading volumes are incredibly small today (like the liquidity in most markets). In Japan government bond trading has plunged since the BOJ began easing in April 2013 with trading falling in May 2016 to the lowest level since 2004 (according to the Japan Securities Dealers Association) .
Whilst market rates are negative, it is only a few people that are actually buying the bonds at these prices (and pushing them higher).
More to the point there are not many people that are selling.
Bond owners are not trading the bonds in question today in large numbers, for one simple reason. They were all originally issued with positive coupons (i.e. they give a positive interest rate on the initial issue price) and if they did sell them (to provide a positive return on what they paid for them) their only re-investment options are into (a) cash at a negative interest rate; or (b) other bonds the prices of which are, well, crazy.
The key point is not many investors (as opposed to the 40% of bond holders implied in the article) actually want to do something that silly.
So, just like you are unlikely to sell your comfortable family home simply because your neighbour five doors down the road sold there for a solid if not crazy price, you are unlikely to be selling your bonds.
You have to live somewhere, and the next place you find will be as equally expensive (if not more so in an upward trending market) as what you just sold for. What’s the point in that?
So the key point is today’s environment of lower interest rates (or higher house prices to continue that analogy) has only led to lower trading volumes. This perversely has only made the market more susceptible to having its day-to-day prices set by the relatively few speculators or punters.
No one else is actually crazy enough to actually buy bonds with negative yields (let alone 40% of the global bond market).
What it does mean however is that we need to be careful in such environments. It doesn’t take many panicked sellers (the few crazy buyers also, as it turns out, tend to be crazy sellers in different environments) to materially move the market price down for a period of time.
Whilst this can make for great headlines and sell a few more newspapers, it really doesn’t affect many of us in the long run.