Negative bond yields mean investors should revamp their portfolios, argues Ceri Jones.
Over the summer, expectations of an economic slowdown and political threats such as the US-China trade war created such high demand for secure investments that more than 30% of the world’s bonds (£13 trillion worth) fell into negative yield territory. This means that investors such as pension funds and insurance companies are now willing to buy bonds for more than their face value and take a loss, because they need the security and liquidity government and high-quality corporate bonds provide.
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Negative-yield bonds and low interest rates have created a topsy-turvy investment world. The two are closely aligned because new bond issue coupons are priced at close to prevailing interest rates.
For example, in Denmark, where banks have been grappling with negative interest rates for seven years, the country’s second-biggest bank, Jyske Bank, is charging customers 0.6% to make deposits of more than 7.5 million Danish kroner (£916,000) and paying borrowers to take out mortgages by giving them 0.5% of their loans.
In Germany, the benchmark 10-year bond yield slid to a record low of -0.61% in August, and yields are now negative on bonds with maturities of three months to 30 years. As a result, some German investors are resorting to storing their cash in secure warehouses.
This upside-down world is unchartered territory because negative interest rates have a short history. It all started with central banks cutting interest rates to mobilise economies struggling to recover from the 2007/08 financial crisis. The National Bank of Denmark introduced negative rates in 2012, the European Central Bank followed suit in 2014 and the Bank of Japan did the same in 2016. It has since proved impossible for the countries under these banks’ jurisdictions to get themselves into an economic position where the banks feel able to hike rates back up to pre-crisis levels.
Negative-yielding bonds are most prevalent in Japan, where £5.8 trillion worth of them are negative, and across Europe. France has £1.8 trillion worth in negative territory and Germany £1.6 trillion, according to Bloomberg. UK and US bond yields have remained positive, however: UK 10-year gilts and US Treasuries yielded 0.51% and 1.68% respectively, as at 26 September.
For a while in 2015 and 2016, many people believed negative interest rates would be temporary, but experts now believe they will persist for eight to 10 years. Bond yields continued to slide through the summer of 2019 and into autumn. One reason for the slump was that at the beginning of 2018 the world appeared to be on the cusp of a co-ordinated expansion, with most developed economies apparently putting the financial crisis behind them. However, in reality, an economic slowdown was setting in. Central bankers such as Jerome Powell, chair of the US Federal Reserve, were adamant that rates would normalise to a higher ‘neutral’ rate in early 2018. But the market crash in the fourth quarter of the year demolished such confidence.
When the ECB cut its rate by 0.1% and the Federal Reserve trimmed its rate by 0.25% in September 2019, the pivot was significant, although these were not big moves in themselves relative to the expected trajectory of rates in the first half of 2018.
Interest rates can’t be cut much further
Stimulus dead end
Central banks form a last line of defence that can loosen monetary policy and cut interest rates to stimulate flagging economies. But monetary policy is already stretched. Central banks are running out of tools to fight recession, as rates are already at record lows. This has fuelled debate about the need for fiscal stimulus, where governments boost public spending or reduce taxes to stoke economic growth. Typically, fiscal stimulus takes the form of investment in infrastructure development, which helps companies in the raw materials, energy and transportation sectors.
Christine Lagarde, incoming president of the ECB, has called on European governments to co-operate on fiscal policy to stimulate the eurozone, and she believes countries with strong economies such as Germany and the Netherlands should raise their infrastructure spending, which could benefit industrial stocks. The Institute for Supply Management’s manufacturing index was down at 49 in September, its lowest reading since January 2016 (below 50 shows a contraction in manufacturing).
Low interest rates and negative bond yields look set to persist for some time, so investors should look to revamp their portfolios. Given the movement in bond markets, it would be prudent to take some profits.
Corporate bonds have already ‘bubbled’. What’s more, they provide meagre compensation for the risks associated with over-leveraged balance sheets, deteriorating economic fundamentals and threats to global growth.
US company debt is at an unprecedented high point, according to Dominick Dealto, chief investment officer at BNP Paribas. Bank lending to sub-investment-grade companies has grown rapidly. Widespread defaulting has been kept at bay only through covenant-light lending.
Real assets should keep pace with inflation. David Coombs, head of multi-asset investments at Rathbones, says gold could rise in value to as much as $1,800-2,000 an ounce. He adds that, in any case, it is always a solid protection against falling US interest rates and volatile stock markets. For exposure to a broad basket of commodities, including energy and agriculturals, his funds invest in the Invesco Markets LGIM Commodity Composite ETF (LGCF) and the Legal & General All Commodities UCITS ETF (CMFP). JPMorgan’s Global Core Real Assets (JARA) investment trust invests in transportation assets, infrastructure and global real estate, including residential and listed real estate investment trusts (Reits), mainly in the US.
David Jane, manager of the Miton multi-asset fund range, tips Japanese Reits, as the yen remains a safe haven and tends to rise in value when equity markets fall. He expects a shift from growth to high-dividend stocks should central banks cut interest rates further. He likes defensive stocks such as Unilever and Diageo that are global and therefore less vulnerable to disruption. He says: “If a rival develops a product that might take market share, these firms will buy it before it eats their lunch.” He also likes Swiss flavours and fragrances firm Givaudan, which provides essential but, crucially, low-cost added-value ingredients for food products and household cleaners .
Private equity markets are big news as the search for uncorrelated absolute returns intensifies. Private equity funds outperformed listed equity funds by 5% over the 15 years to the end of 2017. Consider the Princess Private Equity Trust (PEY) or HG Capital Trust (HGT).
Pawan Singh, head of multi-strategy for alternatives at Sanlam Investments, says Sanlam is launching two alternative funds in November that will focus on private markets. He adds: “Until 2014, globally, listed equities were making double-digit returns, so there was no reason to venture into real assets, especially given the lack of liquidity in private markets, the absence of transparency, the requirement for due diligence and the legal complexity. But it is no longer possible to hang your hat on traditional asset classes and hope for returns that will afford you a comfortable retirement.”