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By: Tim Bennett
28.10.2019
28.10.2019
Negative yields turn the investment world on its head. This week, Tim Explains why and offers nervous long-term investors some reassurance.
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The weird world of negative bond yields
Normally, an investor would expect to be rewarded for lending their money to someone else. However, when yields turn negative, as they are doing across much of the bond world, this rule of thumb goes out of the window.
Background
A combination of central bank activity since the financial crisis over a decade ago and investors seeking a safe place to put their money, has conspired to create an unusual situation whereby bond investors are prepared to pay to lend out capital by buying IOUs. Many retail investors find this concept, unsurprisingly, a little disconcerting.
How common are negative yields?
Far from being an isolated occurrence in some obscure part of the market, negative yields are becoming more and more common.
Nuts and bolts
For anyone wondering how a yield can turn negative, let’s take a simple example. If a bond is issued with a coupon rate of 2%, it offers a positive return in pure interest terms. However, if it is sold for £120 per £100 nominal (a fixed quantity of a bond), then the holder makes a capital loss every year. Ignoring inflation, this is about £4. Combine the two and you have an overall annual yield that is negative.
The causes
To recap, in recent years central banks have been withdrawing the volume of bonds available via what is called quantitative easing. This pushes the price of bonds still available on the open market up and depresses yields, especially when there is high demand for them.
Who buys such a bond?
You might think that few investors would want to buy an asset with a negative yield. But you’d be wrong. The various category of potential customers for these bonds can be split into “strategic” and “forced” as the next two slides illustrate.
For other investors
The remaining question for other investors is what this odd situation means for them. The answer is: not very much, in one key sense. Yes, negative yields on bonds depress the returns available from other assets, such as equities, which tend to take their cue (the “risk premium”) from this market. However, as ever, long-term investors should not be put off – the important thing is whether an asset class such as equities can generate inflation-beating returns for an acceptable level of risk. This core principle has not been negated by recent developments in the bond market even if it does require a bit of a reset in terms of investors’ expectations.
To find out more
Feel free to email me on [email protected] or contact an Adviser for a copy of the latest Confidant, where Mateusz Malek also discusses negative bond yields.
