Central banks and some large European corporations have been flooding the bond market with negative-yielding issues, accounting for 27 per cent of all bonds introduced in 2019 to date and lifting the global stock of these securities to more than US$17-trillion. But while these bonds may appear undesirable because they pay back less than their purchase price, they could be good investments for astute financial advisors and investors willing to play the market.
Technically, negative-yielding bonds are just like any other bonds in that they pay some interest. For example, a 10-year, $1,000 bond can have a $5 coupon every six months. That amounts to $10 a year or $100 in total for the life of the bond. The big difference, though, is that at the end, the redemption price is less than the issue price. So, if the aforementioned bond pays back $850 at redemption, the total “return” is the $100 total interest paid minus the $150 loss – or a total loss of $50. There have also been some German bonds issued that pay no interest whatsoever but are sold at more than their redemption price
Still, negative-yielding bonds – which have been issued by central banks in Germany, the Netherlands, France, Switzerland and Japan along with top corporate borrowers, such as German multinational conglomerate Siemens AG – have been a hit. Banks have been buying sovereign, negative-yielding bonds to meet their capital ratios, a requirement under the international banking rules. Similarly, insurance companies are buying and holding negative-yielding bonds to back the life insurance policies they underwrite.
For retail investors, negative-yielding bonds are not a way to earn income or preserve capital. But when it comes to trading, they’re just like any other bonds. That means if interest rates fall, the price of negative-yielding issues rise. For example, if interest rates decline to negative 3 per cent, then bonds issued with a negative 1 per cent expected total return would be superior and would increase in price, just as a conventional bond with a 3 per cent coupon would rise if interest rates fell to 2 per cent.
Thus, negative-yielding bonds are not keepers to be held to maturity. Rather, they’re for trading, says Benoit Poliquin, president and lead portfolio manager at Exponent Investment Management Inc. in Ottawa. “You want to sell before you take the loss at maturity.” That’s not any different from the trading tactics on traditional bonds bought over the redemption price that will lose value as the maturity date approaches.
Negative-yielding bonds also have a role in foreign-currency plays. For example, buying a 10-year German bond with a return of negative 0.66 per cent with an exchange rate of €0.68 per Canadian dollar will work out profitably if the existing negative-yielding German bond rises in price as interest rates continue to drop. The bond’s potential gain adds to the potential foreign-exchange gain if the euro declines in value against the Canadian dollar.
Furthermore, there’s a role for negative-yielding bonds in the way advisors manage portfolios because these bonds, just like traditional bonds with positive returns, can offset some equity risk. If stocks tumble, bonds would tend to rise in price regardless of their coupons or yields to maturity.
Issuance of negative-yielding bonds is likely to continue as long as there is a global oversupply of cash – and quantitative easing has left the world awash in cash, according to David Rosenberg, chief economist and strategist at Toronto-based Gluskin Sheff + Associates Inc.
That means there’s little risk negative-yielding bonds will disappear from the market. The risk to bondholders is that they will lose value when interest rates rise – that’s the same for traditional bonds with positive yields. But the consensus expectation today is that interest rates will not rise any time soon. In fact, the trend is downward. On Sept. 12, the European Central Bank cut its overnight rate to minus 0.5 per cent from minus 0.4 per cent.
Furthermore, today’s negative-yield bonds could look good if there’s a recession that drives interest rates even lower because negative-yielding bonds issued in the future “will go even more negative,” says Patrick O’Toole, vice president, global fixed-income, at CIBC Asset Management in Toronto.
Nevertheless, there’s still a downside in holding negative-yielding bonds, and that’s “the cost to [investors] in foregone return,” says Chris Kresic, head of fixed-income and asset allocation and portfolio manager at Jarislowsky Fraser Ltd. in Toronto.
For now, the market, which still has a craving for trading negative-yielding bonds, rules. When interest rates rise, holders of negative-yielding bonds will have to accept lower prices – just like holders of any other negotiable bonds. Until then, advisors and investors can look to negative-yielding bonds for trading gains and asset class allocation in portfolios.