Wry & Dry

Why negative yields? TINA.

W&D was brought up in the quaint times when a borrower would pay a rate of interest to a lender on the basis that the interest rate would compensate the lender for the risk of the borrower.  The higher the risk, the higher the rate.  Well, so much for theory.

Ponder the most recent example: The government of Italy, which has a credit rating of BBB-, just two levels above 'junk' status, has just issued two-year bonds at a yield of -0.023%.  And now there are 12 other countries where two-year bond yields trade below 0%, up from just five countries a year ago.

Whaaat? People are paying the government to lend them money!  What is going on?

Negative yieldsWell, firstly, there is so much cash sloshing around Europe from the so-called Quantitative Easing, that institutions are investing at a yield that they believe will go even lower, thereby providing a capital gain.  The fact that the current yield is negative doesn't matter.

So, why might yields go lower?  Currency manipulation: the lower are interest rates the less attractive are deposits in a currency.  The ECB wishes the euro lower to enhance economic growth (exports make up 25% of the eurozones' GDP).  And for competitive reasons Switzerland, Denmark and Sweden, which do not have the euro as a currency, are also keeping their currencies as weak (versus the USD) as the euro. (It's a little more complicated than that: Denmark has a 'managed float' against the euro, Sweden and Switzerland manage their currency by interest rates).  The ECB is not only buying €60 billion of government bonds each month, it also has a negative deposit interest rate: -0.20%.

W&D notes that investors must be somewhat certain of lower interest rates within two years to invest on the basis of a capital gain.

Secondly, and perhaps more intuitively, risk aversion.  That is, investors are willing to pay what is in effect an insurance premium for what they see as safe-haven assets: government bonds.  Hence the truism, the return of money is more important than return on money.

Thirdly, there is also the ecology of institutional investors.  That is, a decision not to invest in government bonds is an active one, which opens those investors to what is called tracking error risk where government bonds are an increasing component of indices used to benchmark investment performance.  This behaviour actually defeats one of the objectives of the ECB, that is, to encourage investment outside of government bonds.   W&D won't discuss this further, as it's a little too complex for a Friday afternoon, when W&D is enjoying a glass of fine Barolo.

So what does all of this mean?  The more this goes on, the more is the mis-allocation of capital in Europe.  As in Australia with 'search-for-yield', the very low government bond yields mean a flow-on to low borrowing costs for others.  And hence borrowers coming to the market at rates that misrepresent their underlying credit risk.  When interest rates go up, as they will, there will be tears.