Holding Bonds Can Still Make Sense Even With Negative Yields

It is almost taken for granted by investors that one should be paid for lending money to a third party. Yet as central banks around the world struggle to ’normalise’ interest rates, there is the increasing risk that at some point in the future bond markets may exhibit negative yields across the curve. Given these risks, it is worth taking a closer look at what negative real yields really mean and what it implies for the ongoing utilisation of bonds by investors.

How does one get a negative yield on a bond?

It is commonly assumed that a negative yielding bond is created by issuing a bond with a negative coupon, though in practice this is not usually the case. In theory, there are two ways an issuer can create a negative yielding bond. The first is to issue a bond at its face value, i.e. the value of the bond at maturity (also referred to as its par value), and then apply a negative yield to the coupon. Though in theory this can be done in practice, it is problematic as the issuer needs to put in place the arrangements to facilitate reverse coupon payments, i.e. facilitate the ability of the buyers of the bond to pay coupons to the issuer. Given this complication, in practice a second approach is normally applied where the bond is issued at a value materially greater than its face value. By doing this, the bond can be issued with a positive coupon and thus avoid the complications associated with reverse coupon payments. The negative yield is achieved on the bond due to the convergence of the issue price to its face value creating a capital loss over the life of the bond. Under this approach, the net return to the buyers of the bond, i.e. the capital loss plus cumulative coupons, will be negative as the capital loss exceeds the value of coupon payments.

How bonds are held may become more important

For investors in funds, this interaction between capital losses and positive coupons to create a negative yield may create a difference between the cashflows generated by the underlying bonds and the fund structures they are held in. The complicating issue is that, in general, bond funds treat all realised cash flows, whether capital gains or coupons, as income. Further, funds can only distribute to unit holders the net income available to the fund. This means that in the event there is a material unrealised capital loss, the fund may be required ‘hold back’ the coupons received during the period to prevent ‘over distributing’ income. Such a dynamic becomes particularly relevant in an environment of negative yields as, on an ‘a priori’ basis, it is known that the capital loss on the underlying bonds in a fund must exceed the positive coupons. Accordingly, it may well be the case that, in a negative yield environment, bond funds may face increased impediments to paying distributions despite the underlying bonds paying positive coupons.

For most investors, this difference in accounting treatment will be of little consequence as the net return between the fund and the underlying bonds will be the same, i.e. it is only the nature of the cashflows which differs. However, there may well be a subset of investors where the nature of the cashflows may be a significant consideration, e.g. investors that are expected to make periodic payments to beneficiaries which may only come from distributions or coupons. For such investors, the ability to receive positive coupon payments from the underlying bonds may be an important consideration. Where this is the case, in a negative yield environment, such investors may have a preference to hold the underlying bonds rather than accessing bond exposures via a fund.

Why hold a bond guaranteed to lose value?

It may appear at first glance that it is counterintuitive to hold a bond which is guaranteed to generate a negative yield if held to maturity. After all, why should a lender, in effect, pay for the right to lend money to someone else? However, this overlooks that the headline yield on a bond is only one of several rationales for holding bonds.

Positive Total Returns

Though the yield to maturity may be negative, it does not necessarily follow that the return earned over a shorter holding period will also be negative. The generation of a positive return in a negative yield environment can occur in two ways. Firstly, though a yield curve may be negative, it does not mean that it cannot become more negative, i.e. rates decline further. Just like positive rates, as rates move lower, investors will earn higher returns. Secondly, a negative yield curve can still be positively sloped and/or non-linear. Such a characteristic provides the potential for investors to earn a higher return from capital gains associated with ‘rolling down’ the yield curve, i.e. buying and holding bonds to realise a capital gain as it gets closer to maturity. Even where yields are negative, active management of bond exposures can still provide scope for returns to be enhanced and may even generate positive returns.

Diversification

The lower absolute volatility in returns means that within a broader asset allocation context bonds still have an important role to play with respect to diversification even when yields are negative. These risk reduction characteristics are especially important in times of heightened risk aversion or ‘distress’. In such periods of heightened risk aversion, government bonds are usually the primary beneficiaries of capital leaving higher risk asset classes such as equity markets. Such characteristics mean that, even if negative yielding bonds are detracting from returns under normal conditions, bonds can still materially reduce the risk exhibited by a portfolio under stress conditions.

Liability Matching

Liability-relative investors are less concerned by the absolute return on their bond holdings. Such investors are more concerned with matching the present value of their assets and liabilities. Given the same factors tend to drive the value of assets and liabilities, the existence of negative yields on assets are less of an issue as their values move in tandem with those of liabilities. For such investors, not buying bonds at negative yields would create a material mismatch and expose them to additional risks.

Deflation Hedge

While buying a bond with a negative yield may appear counterintuitive from a nominal return perspective, it may make complete sense in terms of real yields. The reason for this is that most asset classes struggle in a period of falling prices, i.e. deflation. Bonds, however, retain their value as their coupon and principle payments are fixed. Accordingly, if the decline in prices is greater than the negative nominal yield on a bond, then the return on the bond is still positive in real terms. Negative yielding bonds can therefore still act as a hedge against deflation. Indeed, the very reason that nominal yields on bonds are likely to be negative in the first place is due to the heightened, or perceived, risk of deflation.

Though negative yields in countries such as Australia and New Zealand were avoided in this cycle, in the current low interest rate environment investors need to consider that such an outcome is a very real possibility at some point in the future. Investors may be tempted to dismiss negative yielding bonds as an investment given that they will be detracting from the return on a portfolio. Such a view, however, misses the point that the benefits from holding bonds in a portfolio are multifaceted. Bonds therefore will still have an important role to fill within a diversified portfolio. However, the main potential impact may be on how bonds are held by certain investors since some fund structures may inhibit their ability to pass on the positive coupons paid by the underlying bonds.

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