28th February 2015 by Chris Iggo
The proliferation of negative yields in the European bond market means that some governments might be able to borrow, through bond issuance, more than they will need to pay back (zero coupon, issue price above par). For others, particularly in the periphery, QE should help improve debt sustainability through lowering coupons at a time when a lot of debt has to be refinanced. The process should deliver positive returns to investors in European debt markets in the short run, but we are running out of opportunities to derive income from European fixed income. High yield remains an exception and ultimately investors may also get paid for holding inflation risk. The US and UK markets offer better value in my view, especially when Janet Yellen remains as unwilling to be clear on the timing of the first Federal Reserve (Fed) rate hike as Alan Greenspan used to be on a range of monetary policy matters.
Zero bound? – As far as I know, there has not been a bond issued with a fixed rate negative coupon. Imagine if there was. Investors would be asked to invest in the bond at issue and then make a semi-annual payment to the issuer. If governments were to do this is would mean that investors would not only be lending to the government but would pay a tax for the right to do so. This is different to buying secondary market bonds with negative yields to maturity. In that case the money has already been lent to the borrower. An investor buying the bonds in the market would be doing so in the knowledge that if the bond is held until it matures the value of the cash-flows they receive will be less than the price paid for the bond. But there is no direct benefit to the issuer as it will have issued the bond at par and will redeem it at par (in most cases). Of course, in the case of governments, the indirect benefit to them of market yields going negative is that when they do issue new bonds they can do so at increasingly lower coupons. But not negative. There is a zero bound. The world would need to be really ugly if investors were willing to pay a tax or fee to an issuer over the life of a bond for the right to have that issuer use their money. It would also be an interesting world for credit. The compensation for paying a tax on an investment (that would mean a negative return) is that it would have to be the most solid of solid credits – AAA government risk. If the mind-set of the investor would be to accept that contract then what compensation would be needed to induce the investor to buy a corporate bond where there was credit risk? If the world was so uncertain that investors would be willing to buy negative coupon government bonds then surely corporate bond yields would need to be extremely high.
Cheap borrowing – In practice governments issue zero coupon bonds or bonds with a nominal coupon of, say, 0.125%. They might even combine a zero coupon with an issue price above par, so effectively locking in a loss to a buy and hold investor. The German finance ministry has issued a number of 2-year and 5-year bonds with zero coupons which now have negative market yields. If you buy these bonds at issue and hold them to maturity you will lose a little money and in real terms you will lose if inflation is positive over the period of investment. Given the way the market is going ahead of the European Central Bank’s QE, more and more of the German curve could be generating a negative yield to maturity. The lowest coupon on a 10-year Bund is 0.5% for the one issued in January of this year and set to mature in February 2015 but it might not be too long before Germany is able to borrow interest free for 10-years. France issued a 0.5% coupon 10-year bond in January and Holland issued a 0.25% coupon bond maturing in 2020 last August. Core European governments can basically borrow for nothing today. Will the same ever be seen in the periphery? It’s difficult to see how that could be justified given the lower credit rating and weaker economies of Southern Europe. Yet we do have a 0.5% coupon 2017 Spanish government bond and a 0.75% coupon 2018 Italian government bond. Peripheral government bond yields have moved much lower since the ECB announced QE and there is a strong feeling in the market that yields could go even lower. Spain now trades less than 1% above German Bunds at the 10-year maturity with Italy just above 1% higher than Germany and Ireland at just 60 basis points above Bunds.
QE to improve debt dynamics in Europe – QE is coming at a very opportune time for these bond markets. If the ECB is true to its word and increases its balance sheet by €1.1trillion over the next 18 months or so this will maintain the very strong influence on the level of yields that the ECB has had since Draghi’s famous “whatever it takes” speech. More importantly, QE has the potential to lock in a significant improvement in debt dynamics. If a country can achieve nominal GDP growth that is in excess of its average cost of debt interest then its debt/GDP ratio should start to decline, assuming it does not increase its primary budget deficit. If we take the Organisation for Economic Co-operation and Development’s (OECD) forecasts for average nominal GDP growth in Euro Area countries for 2015 and 2016 and compare that growth rate with the current cost of funding (taking 5-year market bond yields as a proxy) we observe that most countries are in a much better place than they were a couple of years ago. With the exception of Greece, funding costs are now well below nominal GDP growth. The other good news is that growth is improving. There has been progress in reducing primary budget deficits as well. As such, debt/GDP ratios are either declining (Ireland), stabilizing (Portugal) or rising less quickly than they have at any time since the crisis (Spain/Italy). N.B. I leave Greece out of the analysis as it remains a special case. Another reason why this is opportune is because of the upcoming funding requirements for peripheral countries. This year Spain and Italy have a combined refinancing need for €183bn rising to €218bn next year and €242bn in 2017 (according to Bloomberg data). These are hefty amounts and if they can be re-financed at historically low coupons and for longer maturity then the debt profile is again improved.
Better debt sustainability thanks to central bank monetisation 😉 – The risks to this virtuous circle of lower yields leading to better debt sustainability are that global bond yields rise if and when the Federal Reserve starts to tighten or if investor perception starts to be that some central banks are behind the curve; the ECB fails to deliver on the execution of QE; or if the Euro Area is hit by more political shocks. The Greece issue has been kicked down the road and the optimistic interpretation of that is that even a very left-wing anti-austerity government has realized that hurtling towards Euro exit is not the best thing for its economy. That doesn’t mean all things will turn out well with Greece. And there are political risks in other countries too. However, it’s hard to think that the technicals of QE won’t continue to dominate. What the ECB is planning to spend could refinance Spain and Italy almost three times over for the next couple of years. The ECB will end up being the ultimate at-risk creditor of European governments and not getting paid much for doing it as coupons gravitate towards zero. No wonder some traditionalists think this is sailing too close to the wind in terms of central bank financing of government. On the happier side, it has to surely encourage risk taking in Europe through the impact it will have on the cost of capital. If governments can see through much needed structural reforms and reduce obstacles to doing business, the outlook for growth has to be better.
But where is my income? – From a fund management point of view though it makes me somewhat uncomfortable, at least in terms of what it means for returns from government bonds and high grade corporate bonds in Europe in the next few years. There may well be some short term opportunity for excess return in government bonds as QE drives towards the zero coupon world across many curves. Can Spain trade flat to Germany again? Meaning Spanish yields fall by 100% at the 10-year level and deliver more than 10% return if it happens over the next year? Maybe, but the market would have to ignore the ratings differentials (BBB+ vs AAA), or we would need to see the ratings agencies massively upgrade their view on peripheral sovereign borrowers. Back in the mid-2000s when Spain did trade flat to Germany it was rated AAA/Aaa and when Italy traded within 10bps of Germany in 2003 its rating was AA/Aa2. For spreads to keep tightening then the technicals of the ECB buying must totally overwhelm the valuation-fundamental metric. Bulls will argue that in time the fundamentals will improve so valuations won’t look as stretched. If the Euro is here to stay and the infrastructure of EMU has become stronger by being tested since the crisis, then intra-European credit risk should disappear. Of course, we have stopped short of full mutualisation of debt and QE will provide an asymmetric risk distribution through the National Central Banks expanding their own balance sheets, but eh, if there’s a crisis some late Sunday afternoon emergency meetings in Brussels will sort it out.
Anglo Coupons – There are unlikely to be any zero coupon par bonds issued by the US Treasury or UK Debt Management Office in this cycle. We’ve got a couple of sub-1% coupons for 2-year US notes issued last year but as the feeling is the Fed will raise interest rates this year, attempts to borrow for zero would probably not go down too well with investors. The last month has seen a bit of term risk premium returning to the US and UK markets with 5-yr yields up 26bp from their lows in the UK and 35bps in the US. I still don’t believe the yield curve compensates investors for the risks of future interest rate increases but at least there is a bit more value, and relative to the Euro curve you would definitely prefer to hold treasuries or gilts. The benchmark 10-yr US government yield is over 60bp higher than the Italian equivalent yet I bet most investors are underweight treasuries and overweight Italy. Sterling and dollar investment grade credit also offer better value than European corporate bonds, especially for income focused investors.
Inflate me –What has pleased me most this last month has been the recovery in break-even inflation rates in the UK and US, even with lower actual inflation prints. The market does not believe we are at risk of deflation. Indeed as the evidence mounts that labour market tightening may ultimately lead to wage growth and higher inflation when the oil price effect washes out, inflation spreads have picked up. This is consistent also with the more upbeat message coming from the equity market and the high yield market, both of which have had a very strong February. Record highs in some equity markets, a 2% plus return from high yield, duration underperforming, break-evens wider. That all sounds very risk-on and happy. Doesn’t really jive with the mood amongst financial services employees or the commentary coming from analysts and the media. Unless the data changes direction, I suspect some of these trends could continue. If there is still a search for yield then it has to be in high yield bonds and dividend paying equities.
The price of money – There has been a lot of news in the markets already this year but, apart from geo-political concerns, most of it has centered around the deflationary risk in Europe, the ECB’s response to it and the impact of this on other central bank policies. The net effect has been a weaker euro, a stronger Swiss franc, QE from Sweden, and the proliferation of negative interest rates. In a chat with a credit strategist this week we discussed negative bond yields and he made the point that in some cases zero coupon par bonds may still be preferable to negative returns in wholesale money market accounts. Central banks penalize banks for holding cash on deposit so banks have to charge negative interest rates themselves in the wholesale market. No-one wants the money. It’s not that there is no money. This is itself becomes deflationary if the structure of interest rates causes a collapse in the velocity of money in the economy. The good thing is that borrowing is up. Companies are using the opportunity of low yields to raise money. This week we have seen a lot of US companies issuing bonds in Europe. Hopefully some of it is being used to finance investment. In Europe I still believe that the key is on the supply side. QE is giving countries the opportunity to lock in very low borrowing costs for longer maturities. Sense might prevail and we might see tax reform and some fiscal stimulus to get investment up and unemployment down. Otherwise, the secular stagnation world of negative yields might be with us for a very long time.
Richest does not mean best – With the possible exception of Chelsea, English football teams have fared very badly in European competition this year. That makes me feel somewhat better about Manchester United not being involved, although the way they are playing I am sure they would not have done any better. It’s interesting because the marketing around the Premier League is that it’s the best in the world and has many of the world’s best players (Falcao?). It may be the most competitive and certainly is the richest but it doesn’t necessarily deliver the best teams or the best quality of football. Maybe it’s too rich. As we’ve seen in economics, throwing money at something doesn’t necessarily make it better. Perhaps the players get too obsessed with money and not obsessed enough with glory. I hope that the recently announced television deal results in more money at the grassroots, more investment in community football and coaching and cheaper tickets or better facilities for the supporters. The money so far doesn’t trickle down that much. My other team, Sheffield Wednesday, has just been taken over by Thai investors (gulp). It was saved from bankruptcy a few years ago, but the stadium has become shabby, the pitch more or less unplayable and the first team is generally cobbled together from old pros or loanees and this is a club that has a strong fan base. So, like with the Euro Area, English football needs some structural reform or all that money will just mean more inequality, poor performance and just inflation. It’s hard to see a Villa or Forest ever being crowned European champions again.