Wednesday, 20 July 2016 - 20:00
Seed Weekly - Investment Strategy in a Negative Interest Rate Environment
My last article discussed various investment manager styles. Included here were styles such as top down, value, contrarian, growth, quality, momentum etc.
In this article, we explore possible investment strategies and some specific reasons why investors would be explicitly “investing” cash at a negative nominal interest rate, i.e. investing with the guarantee of receiving back less in nominal terms after a defined period of time. Because such an investment approach goes against our normal understanding of investments, it is difficult to believe that an estimated amount of over $10 trillion is already invested into negative yielding assets in the form of mostly government but also corporate bonds.
As an example, last week it was reported that the German Bundesbank issued €4 billion, 10 year bonds at a yield of negative 0.05% p.a. yield. In this instance investors were prepared to part with a substantial sum of money, with the explicit promise that they would receive a haircut of 0.05% each year off their initial capital invested.
This is a classic case of investors being so risk averse that they are more concerned with the return of their capital than their return on capital.
So let’s look at some reasons why investors would adopt this as part of their overall investment strategy.
One investment approach adopted by many pension funds is the matching of their liabilities with assets. This is known as LDI or liability driven investment. This is an investment style that is focused on the liability side of pension funds. It is mostly defined pension funds that will look to adopt this strategy because they have a defined liability in the form of a promise to their retired employees, which can be actuarially calculated on a year by year basis.
In order to immunize this liability, pension funds will set aside a portion of the portfolio investments, investing into lower risk bonds. This worked well when bonds yielded higher rates, but many pension funds continue to invest even as yields drift lower into negative territory. It can be justified if, due to deflation, the pension funds liability is decreasing.
Another buyer of “lower risk” government bonds are insurance companies. Due to increased capital structure regulation, insurance companies own increasingly greater amounts of “less risky” assets. In the past and in order to match their long term liabilities they are “forced” buyers of government bonds.
Therefore, yields are low and governments are able to issue bonds at these low yields and even negative yields, because there is huge demand.
• There is demand from risk averse pension funds.
• There is demand from central banks that are buying bonds issued by government treasuries as a form of quantitative easing.
• There is demand from the risk averse global savings market, which is generally running higher than new issuance. Because of high demand, governments issuing are able to price yields at lower and lower levels.
• Another reason is that global investment managers manage according to benchmarks. Where global bonds make up a portion of the benchmark, the decision to not allocate to bonds, becomes a “risky” investment decision, relative to the benchmark and peers. This becomes especially pronounced where the return on bonds has done well. Therefore despite the low and negative yields, investment funds are “forced” to buy bonds.
According to global bond manager, Pimco, low and negative yields can be pointing to a sharp economic downturn, i.e. a deflationary environment. In this instance investors buying negative yields bonds may still receive a positive real yield, where inflation turns to deflation. For example the real return on a negative 0.05% coupon can translate into a positive 1%, where there is deflation of 1.05%.
The Economist has called this “slow suffocation” because given the preponderance of negative interest rates, banks and other financial services firms’ profitability will ultimately be hit hard. Not only that but virtually all other investment assets are priced off global bond yields, by adding a relevant risk premium. It therefore makes a difference to all global investment assets, when the starting position is a negative.
The chart below reflects the steady increase of global funds now invested into negative interest yielding bonds.
Chart 1: The pool of global negative yielding debt is climbing
Source: The Wall Street Journal 18 June 2016
So while there may be lots of reasons why investors, mostly institutional type investors have lots of reasons to “invest” into negative yielding bonds, they are not necessarily making rational investment decisions.
Ian de Lange
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