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Investors racing to the bottom

7 February 2015, De Telegraaf

The return on bonds -the yield - continues to fall. Yet despite this, large sums continue to flow into bond markets, rather like air being pumped steadily into a bubble. Investors looking for a fixed income are finding things increasingly difficult.

Five years ago, anyone saying that a company would be able to borrow money for nothing would have been declared insane, and yet this is precisely what has happened in the meantime. Investors in short-term euro bonds (term 2012-2016) in the Swiss company Nestlé recently had to accept a negative yield.


We should point out here that a negative yield does not mean that investors received no return. The original nominal interest coupon on the bond is still intact. It’s just that in the meantime, investors are paying so much above the nominal value of the bond (the value against which the loan is repaid) that they are effectively making a negative return if they retain the bond until maturity. In practice, this is called a negative interest rate.

In fact, Nestlé is now able to issue a new, short-term loan with a nominal interest coupon of zero per cent. By selling this loan above the nominal value to investors, a negative yield is created immediately upon issue. The interest coupon can never recoup this nominal loss.

The main hope for a positive return for investors when there are low or negative yields is that bond prices rise; as a result, yields will then fall further. The bonds can then be sold for a profit before they mature.

Foreign exchange gains represent another opportunity for making a profit. If the value of the currency in which the bond is issued rises, the value of that bond will rise in parallel. This explains, for example, why investors in the euro zone can still see a return in Swiss government bonds a significant negative yield. If the Swiss franc rises further in value against the weak euro, they can achieve a positive return. This also opens up possibilities for dollar bonds. Moreover, in the US, interest rates are also higher than in the euro zone.

Yet another reason for an investor to accept a negative yield is anticipated deflation. The purchasing power of the future redemption will then be greater than the (nominally higher) current bond price.

Short-term government bonds from countries such as Germany have been offering a negative yield for some time. The ten-year rate on bunds also appears to be heading along those lines. In the Netherlands, the yield on ten-year government securities is currently approximately 0.4%; in Germany 0.35%. So why are investors satisfied with this? One of the reasons is that yields may fall further as the result of the ever-increasing influx of money. This results in an exchange rate gain. The European Central Bank’s bond purchasing programme is the main inspiration behind this scenario of a race to the bottom.

However, many of the major institutional investors are required to invest in bonds. They find themselves stuck in a specific investment mix on account of regulations and risk policy. Bonds also occupy a significant place in the pension investments made both by institutions and private individuals.

“For many people, bonds are seen as a safe haven. Long-term rates have been falling on balance since the end of the nineteen eighties,” according to Victor Zwart of asset manager Wealtheon, in outlining the past. “Lower coupon income has been offset by attractive price gains. After over thirty years, this now seems to be coming to an end. A major tipping point is just around the corner.”

Bond investors, who always have to dig deeper to unearth returns, are looking more and more to other forms of investment that offer a higher return. Those investors who can are making changes to their investment mix, according to Zwart. “A great deal has been said about the importance of bonds falling away and an increase in the weighting of equities. This is understandable in view of the low returns on quality bonds. The outlook is for returns to stabilise over time or even rise.”

Rising interest rates leading to falling prices is a nightmare scenario for many bond investors. Zwart , too, sees it as a bubble that might well burst. “The prices of practically all forms of bonds have risen substantially,” he says. “The question is when the bubble will burst. For that to happen, rapidly rising interest rates are required in the euro zone, which would trigger a selloff. But based on the outlook for inflation and the ECB’s decision to buy up bonds on a large scale, this particular scenario still seems unlikely in the euro zone in the months ahead.”

But if interest rates should suddenly rise sharply, it will mainly be bondholders with a long remaining term who will suffer the most. This duration, more accurately termed as the weighted average period of future interest payment and redemption, is often used to calculate the interest rate sensitivity of bonds.

The longer this duration, the more bond prices are sensitive to change in the market interest rate for the bonds. A 1% rise or fall in the interest rate will lead to a corresponding fall or rise in bond prices by a percentage equivalent to the duration.

If that duration is six years, then the bond price will fall by 6% if interest rates are 1% higher.

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