Not so long ago
The idea that an investor would pay to lend money over any time period, much less over 30 years, was more or less academic before 2009. In that year, in the depth of the financial crisis, Sweden’s central bank cut its overnight deposit rate to –0.25%. The European Central Bank (ECB) and the Bank of Japan (BoJ) followed suit in 2014 and 2016, respectively, marking their policy rates down to negative territory and bringing the concept firmly into the mainstream of monetary policy.
Today, the vast majority of bonds in Europe and Japan—upward of 30% of all investment-grade debt in the world—carry negative yields to maturity. Nor is the phenomenon limited to short maturities: This past August, Germany sold 30-year sovereign debt at a negative yield for the first time. The €824 million bond issue will pay zero interest and will return just €795 million in principal when the bonds mature in 2050.¹ Even some corporate bonds now trade at negative yields, and of course the scale of the situation becomes much greater when inflation is taken into account. While more than $17 trillion in global debt traded at negative nominal yields as recently as September 2019, the figure jumps to nearly $36 trillion in real terms and extends beyond Europe and Japan. In fact, more than $9 trillion of U.S. government debt now trades at yields below the rate of inflation.² The era of negative-yielding debt has arrived.
How we got here
There are a number of explanations for why we’ve entered this alternate fixed-income reality, but the primary driver is central bank policy. In Europe and Japan, traditional monetary policy, including near-zero reserve rates, has proven incapable of stimulating economic growth. Now central banks there are trying to force lending and inject money into the economy by effectively penalizing commercial banks for storing their reserves. The associated decline in currency values is another deliberate economic stimulant in those countries where exports are crucial to growth.
Beyond policy rates, ongoing quantitative easing by central banks is pushing up the prices of longer-dated bonds and pushing down yields. Bond buying by the ECB and BoJ has been so dominant that it’s effectively crowding out private debt ownership, reducing, for example, the portion of available sovereign debt in Germany and Japan to just 31% and 57%, respectively.³
Exacerbating these issues is investor demand for income. Yield-starved investors are chasing after income wherever they can find it, bidding up the prices of those bonds. This cohort includes institutional investors with investment-grade mandates, but also demand from passive strategies with fixed allocations to sovereign debt. At the end of November, a stunning 22% of the Bloomberg Barclays Global Aggregate Bond Index carried a negative yield, led by the index’s sovereign allocation, of which 31% was negative yielding. The figure jumps to nearly 40% of the BofA Merrill Lynch Global Government Bond Index.⁴
The safe-haven status of government bonds plays a role, too. Sovereign debt continues to represent a risk-free asset, so fearful investors who don’t like what they see on the economic horizon are accepting negative yields in exchange for safe harbor, or betting that they’ll earn a positive return as negative yields get even more negative in the future. We’re seeing this latter strategy grow more popular among momentum investors.
Distortions and knock-on effects
Our new normal of low-to-negative yields is having a ripple effect across capital markets and the real economy. In the first six months of 2019, some $250 billion in cross-border capital flows came into the United States, pushing down U.S. yields but also stretching the valuations of bond proxies, such as real estate and utility stocks. Japan has been a particularly large net buyer, accounting for roughly $300 billion of bond and equity purchases on an annualized basis in 2019.⁵ Where investors are finding positive-yielding bonds, they’re adding duration risk to make the most of it.
Credit risk is also on the rise, with investors generally moving down in quality to pick up incremental yield. Far from late-cycle euphoria, however, investors have been more discerning about how much credit risk they’ll take; the long, muted recovery hasn’t inspired much confidence, and today’s investors seem skeptical that the credit cycle can sustain recent returns. So, while the trend has been to take more credit risk broadly, higher-quality credits have outperformed the most speculative credits.
The era of low interest rates has also sparked a widely reported explosion in corporate debt issuance. U.S. corporate debt now exceeds $15 trillion, more than double the previous peak reached in 2008 and approaching 75% of GDP.⁶ While higher levels of debt issuance aren’t necessarily a problem if economic growth continues and rates stay low, it significantly increases tail risk scenarios if growth were to slow materially. Spreads are severely compressed in many areas as a result of today’s yield-chasing dynamics, and in some cases we believe investors are not being fairly compensated for the risk they’re taking. Add to this scenario the growing uncertainty surrounding trade, Brexit, and the 2020 U.S. election, and we can imagine corporate debt becoming a source of outsized volatility.
A sharp downturn isn’t our base case, but if it were to happen it would be especially painful. A pullback in the United States that pushed credits to junk status would force selling from institutional managers and likely trigger home country bias repatriation. With balance sheets at or near all-time highs, rates low to negative, and bailouts unpalatable, central banks no longer have the tools they once did. Liquidity is generally not an issue until it is.
Negative rates may not worsen, but they'll persist
Barring such an economic downturn, there are a few reasons why we believe negative rates won’t expand significantly from here. For starters, sub-zero rates aren’t working as well as policymakers had hoped. Five years after crossing the proverbial interest-rate Rubicon, signs of economic success in Europe and Japan remain fleeting. Unemployment remains high across much of Europe, capital spending hasn’t rebounded much, and GDP growth appears to have stalled. Meanwhile, inflation has actually weakened in Japan, despite all the stimulus, and it remains well below the 2% target in both regions.
Negative interest-rate policy has also had a number of undesirable side effects in the real economy that policymakers are keenly aware of. Today’s low-rate regime has hurt savers, pensioners, and anyone else relying on deposit-based income, while proportionately benefiting equity and real estate investors. Policymakers are concerned about the formation of asset bubbles on the one hand and about the growing income inequality between savers and those who have access to capital on the other.
Negative rates have also squeezed the net interest margins of banks that pay a penalty to store excess reserves but that are unable to pass on negative rates to depositors (who would deposit money in a negative-yielding bank account?); European banks have lost more than a third of their market capitalization since January 2018 as a result.⁷ Some central banks have even reported that commercial depositors have asked to store cash in vaults to avoid being penalized by negative rates. Lowering rates further into negative territory only worsens this issue. In the corporate sector, negative rates can also create a moral hazard of sorts as companies confuse cheap financing with sound capital investment, or where marginally profitable companies remain in business due purely to the low cost of capital.
Despite the many flaws of negative interest-rate policy, investors should expect low-to-negative rates to persist for some time. Inflation rates remain stubbornly below policy targets across many developed markets, with massive debt burdens, globalization, aging demographics, and technology-related price deflation all applying downward pressure. Aging demographics alone may imply structural changes to inflation and yields, with lower levels of household formation on the one hand and greater demand for fixed-income assets on the other.
Even when policymakers express a desire to reverse negative rates, it’s proving difficult to do. Central bankers are reluctant to give up negative rates in large part because it could dampen their economies further. The fact is, central banks aren’t in a great position to stimulate growth. Most would prefer to use traditional measures, but nontraditional levers are all that remain, the use of which comes at a cost to their credibility and society. Longer term, we expect to see banks trying to balance credibility with extraordinary measures.
Fixed-income managers need more tools at their disposal
In a world of low-to-negative interest rates on risk-free assets, fixed-income managers will need to get creative. We believe generating income today is a fundamentally active endeavor that requires both a global research footprint and deep expertise across a wide range of less traditional strategies. Rather than merely adding risk, however, the benchmark of successful fixed-income management will be the degree to which a manager can generate income without materially altering a portfolio’s risk profile.
There are no silver bullets for operating in today’s environment. What follows are some of the capabilities we’ve employed at Manulife Investment Management.
- A global research footprint—We have investment teams in North America, London, and in 10 countries and territories across Asia. Our global footprint means our teams are exposed to local developments on a timely basis, and we try to leverage that insight across the organization. Having boots on the ground may not always result in security-specific ideas, but our experience is that teams with firsthand local knowledge have a better chance of putting events into perspective, which can lead to better decision-making and more effective risk management.
- A capital structure agnostic view—To succeed in today’s fixed-income landscape, portfolio managers must have the agility to pursue opportunities across the capital structure. Our team utilizes a combination of macro perspective and fundamental security selection to construct portfolios, but the various subteams bring their specific recommendations on how to best achieve that allocation. If a portfolio manager has a fundamental view of a credit and thinks the spread will narrow, he or she will want to extend duration on that company with a long-dated bond. In other cases, the preferred security may generate more income, or we may choose a floating-rate loan to manage interest-rate sensitivity in the broader portfolio. Alternatively, we may find that equity exposure is the most effective way to express our fundamental view. It comes down to valuation and risk tolerance.
- High yield—We find that high yield can be an effective, lower-risk proxy for stocks. Over the past 25 years, the category has generated 76% of the S&P 500 Index’s returns with only 53% of the volatility.⁸ At the same time, adding credit risk at the expense of interest-rate risk can also provide valuable portfolio diversification. (People tend to forget that there’s plenty of risk in interest-rate risk.) So when rates are going up in a particular market, we’ll often shift to emphasizing credit risk instead. Fundamental research is critcal when investing in high-yield credits globally. Actual credit risk varies greatly by region, no matter what the ratings say. Statistically, a B-rated credit in Latin America has a much higher likelihood of default than a B-rated credit in the United States.
- Emerging-market debt (EMD)—Our global footprint has helped us take advantage of this compelling asset class. In Asia, where we cover more than 500 issuers, we see a number of sovereigns with high and improving credit ratings. Asian bonds are largely under-represented in global EM indices—certainly relative to Asian equities—so this is another area where fundamental research and active management can provide an edge. Our approach opportunistically combines local currency positions with dollar-denominated bonds, giving us lots of opportunity to pursue incremental alpha.
- Preferred securities—Preferreds can offer high-yield-like income but with a more compelling profile and preferable treatment of dividends. Due to their fixed income, these securities have historically performed well in periods of easing or when monetary policy is on pause. We also find the concentration of issuers in the financials, communications, and utilities sectors can be complementary to a sleeve of high-yield bonds, where issuance largely comes from other sectors.
- Option overlays—We’ve also used a combination of covered equity calls (buywrites) and cash collateralized equity puts (putwrites) to generate additional income in portfolios with a significant distribution objective. While not eliminating risk, we observe that the premiums collected on selling options can provide a buffer of protection against return drawdowns. In effect, by using short options to convert equity upside into a reduced downside risk, the strategy transforms equity exposure into a very high yield bond-like risk profile. This high yield-like exposure typically garners similar income while providing diversification benefits when used in conjunction with traditional high yield bond holdings. And the combination of both covered calls and putwrites can provide significant income stability over time versus utilizing either of the strategies alone.
- Currency management—Active currency management is another way to add incremental return and manage risk. We routinely use FX to convert negative yields into positive yields through FX hedging. Currency is also an unparalleled source of liquidity in capital markets, and currency markets are almost always open.
Opportunities exist for those who know where to look
Negative yields present distinct challenges for fixed-income investors and our global economy. While a severe downturn isn’t our base case, we believe the global interest-rate environment will stay in a lower-for-longer state for at least the next three to five years and that higher-yielding, higher income-generating asset classes will remain well bid. In my 30+ years of investing experience, however, I’ve found there are always places in the world where things are improving on a fundamental basis, and there are countless opportunities for actively generating income across geographies and the capital structure. The successful fixed-income manager of the next decade will have the depth of skill and the breadth of capabilities to do just that.
1 Wall Street Journal, August 2019. 2 Bloomberg, September 2019. 3 Global Markets Daily: Negative-Yielding Debt—Flows and Spillovers, Goldman Sachs, August 2019. 4 Bloomberg, November 2019. 5 Exante Data, 2019. 6 U.S. Federal Reserve, July 2019. 7 Bloomberg, measuring the market capitalization of the MSCI Europe Banks Index, as of August 31, 2019. 8 Bloomberg, measuring the market capitalization of the MSCI Europe Banks Index, as of August 31, 2019. 9 Source: JP Morgan, data as of September 2019.
A widespread health crisis such as a global pandemic could cause substantial market volatility, exchange trading suspensions and closures, and affect portfolio performance. For example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future, could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other preexisting political, social, and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment
Investing involves risks, including the potential loss of principal. Financial markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. These risks are magnified for investments made in emerging markets. Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a portfolio’s investments.
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