Just how much lower can bond yields go?

Just when investors think that yields cannot possibly go any lower, a new record is broken. Usually this would be triggered by a major event such as uncertainty over the Greek elections, but this time it is different, says Daalder, Chief Investment Officer for Robeco Investment Solutions.

And while investing in an environment of negative yields may seem pointless as it would imply actively seeking to make a loss, there are many reasons why we have ended up in that situation, he says.
“You know that something out of the ordinary is going on when clients no longer appear to be primarily concerned about the remaining up- or downside for stock markets, but rather on how much lower yield in the 10-year government bond markets can go,” Daalder says.

Uncharted territory

“The expectation that the trend of ever-lower yields would finally be broken in 2014 once again turned out to be incorrect. Fed tapering or not, bond yields continued to trend lower, with especially European bonds moving in thus far uncharted territory.”

“And it was not just a European phenomenon, as yields across the globe trended lower. Even Japanese 10-year yields touched an unprecedented level of 0.3% at the end of the year. So the ‘million-euro question’ is how much lower can bond yields – and specifically 10-year bond yields - drop?”

Daalder says the answer much depends on the future policy of the European Central Bank (ECB), with the negative deposit rate of minus 0.2% specifically acting as a floor. Massive quantitative easing measures by the ECB and other central banks, notably in Japan, will keep the pot boiling for much longer, he says. The ECB has a EUR1 trillion QE program while Japan’s Abenomics is virtually infinite.

“The open-ended shock-and-awe QE measures announced by the Bank of Japan at the end of October gradually pushed Japanese bonds down in the months that followed, with 10-year yields posting a new low of 0.2% in the middle of January,” he says.

‘European bonds moving in thus far uncharted territory’

Worse than a ‘worst-case’ scenario

“As for Europe, thanks to the anticipation of QE measures by the ECB, German bonds never even paused at the assumed ‘worst-case’ 0.5% level, with 10-year yields declining to a level of 0.3%. The real shocker however proved to be the Swiss bond market, where the whole yield curve with a maturity of up to 12 years was pushed into negative territory following the decision of the Swiss central bank to let the peg with the euro go.”

And the ‘worst’ thus far could worsen. “The new ‘worst-case scenario would be negative yields, but even this is not a new phenomenon for shorter-dated bonds,” says Daalder. “Back in 2011, at the height of the euro crisis, yields on German 1-year bonds dipped below zero, as investors fled the peripheral bond markets. Paying a small negative yield felt like a much better deal than facing the odds of losing everything if the Eurozone broke up.”

Daalder says that according to the calculations of JP Morgan at the end of January, a total of USD 3.6 trillion in government debt (16% of the total) was trading at a negative yield. But why would an investor be willing to invest money in an asset that will guarantee a loss?

Still attracting investors

“It’s true that taking the money and putting it under the mattress would yield a better result (i.e. zero percent), but this is not an option open to financial institutions,” says Daalder. “There are a number of arguments why it even may make sense to invest in a negative yield environment. Some of these are speculative in nature, but some of them are logical given the economic and financial environment we are part of.”

He cites five main reasons why negative yields may still attract investors:

• QE by central banks: Bond prices are simply the outcome of supply and demand, and massive bond-buying programs will continue to prop up demand
• Deflation: Investing in bonds with a negative yield makes perfect sense if you expect prices to fall even more. You may lose in nominal terms, but in real terms you still end up with a good result
• Expected capital gains. Even with a negative yield curve, it is still possible to make a profit on any positive price movements, especially if investors are running down the yield curve
• Currency expectations: A positive currency movement can realize a profit, such as for investors who bought negative-yielding Swiss bonds and then benefited when the Swiss franc was revalued
• A negative deposit rate: The move by the ECB to lower deposit rates to minus 0.2% means a negative yield on a bond might be a better option for a bank with excess cash to deposit.

‘It’s true that taking the money and putting it under the mattress would yield a better result’

“Taking all the previous arguments together, and barring situations of speculation, the answer to the question of how low bond yields can actually go very much depends on central bank policy,” surmises Daalder.

“So far, the ECB has been pretty vocal that it considers the current minus 0.2% rate to be the lower bound, which means that, for now, this appears to be the new worst-case outcome.

“But with short rates fixed and in negative territory, the first logical implication will be that the search for positive yield is going to continue. To put it differently, we are running out of options within bonds.”