It's been an interesting few years for central bank policy makers, to say the least. After years of ongoing monetary stimulus we find ourselves in a world with little growth, nearly zero inflation and shrinking aggregate demand.
Out of all the outcomes caused by accommodative monetary policy, one of the most perplexing is that nearly $12- trillion of government bonds – about one-third of the global government bond market – now trades with a negative yield. This has many people wondering why any rational person would lock themselves into a security with a negative return.
While we have no intention of investing in negative yielding securities at Gluskin Sheff, why others would is still an interesting question and one that we will seek to answer here.
Understanding market behaviour
Before we delve into negative rates, it's important to revisit how market participants operate. One of the main principles of economic analysis is that an individual makes decisions based on the best outcome for him or herself.
But not all participants are looking for the same outcomes. Indeed there are many types of participants who have different interests and priorities. This is what makes a market in the first place: people coming together who have varying perceptions of value for goods and services. After all, if everyone valued a good at the same price then no exchanges would ever happen.
It's also worth noting that not everyone is preoccupied with maximizing profits or returns. There are many participants in the financial markets with mandates that extend beyond just trying to cash in. This is important to remember as we delve into negative rates.
Negative interest rates aren't new
From a technical perspective, we have already seen negative interest rates for years. If you take the interest rate of a bond or a loan, and deduct the expected inflation over the life of the investment, you're left with an interest rate in real terms ("net of inflation"). Anyone invested in a bond that has delivered below-inflation returns has, in fact, been losing money over time and has been receiving a negative interest rate. This has been the case for a large amount of short-dated bond securities for many years.
Even so, it still makes sense to buy these bonds because the nominal rate – the stated interest rate irrespective of inflation – has been positive. But that's changing now, with nominal rates in many parts of the world now firmly negative.
With inflation still a positive number, and nominal rates in negative territory, real rates have become even more negative than they were before. Not only is a fixed income investment unlikely to be keeping up with the cost of living, it's now underperforming a pile of cash!
Why invest in negative rate securities?
Not everyone invests for the same reason. There are people and institutions who want to buy securities to make money and there are those who are willing to earn a negative return because they need a safe place to stash their dollars.
Many investors are willing to accept some cost on short dated fixed income instruments because they need a place to store cash. While retail investors enjoy interest paid on their bank savings accounts (albeit at a low rate), institutional investors do not enjoy the same treatment. A large pension plan holding millions of dollars, for example, cannot simply invest that money in a regular bank savings account – if it tried, any bank it dealt with would charge them at least the same negative interest rate that their respective central bank currently charges them.
So why don't they just keep their money in a safe or under their mattresses? Well, a pile of cash isn't costless either. Having a few thousand dollars in bills in a safe is manageable, but to think of holding millions of dollars in bills requires some thought and would entail storage costs (building a large enough safe, hiring guards, etc.).
Institutional investors therefore seek out bond securities that pay a better rate of return than they would receive if they were to deposit the cash directly at a banking institution, which, by the way, has resulted in unprecedented demand for short-dated bond securities, exacerbating their low returns into negative yields.
Many types of investors are constrained by government regulations. For example, in some jurisdictions pension funds are forced to pass something called a 'duration gap test'. These pension funds need to calculate the duration of all their assets and the duration of all their liabilities, and the difference between the two values must be lower than a prescribed threshold. Fixed income instruments happen to have the exact duration characteristics pension funds need to match their liabilities. Hence they look to buy bonds not for their return characteristic, but for their duration characteristics.
Insurance companies are also a good example of an industry affected by this type of constraint. The insurance business collects premiums and invests this money while waiting to pay out claims. Regulators want to ensure that these companies have money available when a claim is registered, so they are focused on the quality and level of risk of the assets in which the money is invested. They're not investing for their return characteristics but rather for their regulatory capital characteristics.
In addition to this, under new banking regulations banks are forced to hold a certain amount of their assets in a form that is considered a High Quality Liquid Asset (HQLA). Government bonds and reserves at the central banks are assets that are considered HQLA. So again, a situation where an investor class, this time the banks, wants to own bonds not for their "return" but to check a regulatory box.
Some levered investors, like banks or hedge funds, do want to own securities for a return. However, they care less about the outright level of yields and more about the spread against their funding costs.
It is the shape of the interest rate curve that matters to them, not the level. For example, in Europe, while 10-year German bonds yield around -5 basis points (-0.05%), short-term funding rates are closer to -30 basis points (-0.30%). So a levered investor can borrow money at -30 basis points to invest at -5 basis points.
This is the classic "carry trade" that some fixed income investors love to exploit: borrow short to lend long. There are risks to this strategy depending on future changes in interest rates and the shape of the yield curve.
"The Greater Fool" theory
When asset prices are elevated or mispriced, often times investors will buy them on the assumption that someone will pay an even higher price in the future. This is "The Greater Fool" theory of investing.
This is risky. To make an investment in an overpriced security based on one's ability to find a future buyer would seem to qualify as irrational. But when central banks have stated that they need to buy large quantities of certain types of securities at any price, they're basically willing to step up and wear the fool cape and hat.
Summing it up
The fact that institutional investors are currently buying large quantities of negative yielding securities for non-economic reasons has distorted the traditional structure of capital markets, but we believe that the current status quo is not sustainable in the long-term. Central banks will likely introduce new policies in the coming years to stoke inflation, thereby causing yields to normalize, and causing tremendous volatility in the prices of the government and corporate bonds that currently deliver negative yields. Investors must be ready for this volatility as this upside down interest rate environment continues, and remember that a large part of the negative rate environment is being driven by participants who must buy bonds at any cost, irrespective of the return.
This piece is a broad statement that goes beyond just bonds into all other asset classes. Market prices are shaped by a multitude of forces, and investors should consider and understand them all. An investor's ability to put themselves in the shoes of other classes of investors enables them to find opportunities for their clients.
George Young is Gluskin Sheff + Associates Inc.'s Managing Director, Asset Mix & Risk Metrics, responsible for monitoring overall portfolio level risk and providing analytical leadership to the Firm's Asset Mix Committee.