Zero Interest

Finding a Plus in Minus Territory

  • Why it matters

    Why it matters

    The global era of zero interest rates, which shows no sign of ending, is redefining basic investing assumptions. Despite negative returns on standards investments like bonds, the financial industry is continuing to buy for lack of alternatives.

  • Facts

    Facts

    • The yield on €2 trillion in outstanding European sovereign debt is now in negative territory.
    • The ECB’s plan to buy €1.1 trillion in European debt will only prolong the phase of negative interest rates.
    • Professional money managers are continuing to buy bonds with negative returns because they have few alternatives.
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    Audio

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euro coin

The European Central Bank caused an outcry in June 2014 when it ventured into uncharted waters to stimulate lending in Europe: For the first time in history, interest rates on deposit accounts slipped into negative territory.

The head of the Bank for International Settlements, Jaime Caruana, warned that the consequences were “anything but clear.”

After all, the entire architecture of the financial market is based on the fact that savers are rewarded and borrowers pay a fee for the privilege of borrowing.

But this basic principle of capitalism no longer applies.

Eight months later, it is becoming apparent that the ECB’s ultra-lax monetary policy has created a negative-interest economy. Yields have entered the negative zone in one investment class after another.

The total yield on €2 trillion ($2.26 trillion) in outstanding European sovereign debt is now in negative territory.

It is becoming apparent that the ECB's ultra-lax monetary policy has created a negative-interest economy. Yields have entered the negative zone in one investment class after another.

On the whole, Europe’s finance ministers have been able to turn a profit with a third of their government bonds.

By the time that ECB President Mario Draghi announced in January that the central bank would buy sovereign debt worth €1.1 trillion in the next year and a half, it was clear the suction of the negative interest-rate environment would grow.

This has been the case with development banks and supra-national institutions such as the euro bailout fund for some time. A quarter of bonds are yielding negative interest.

Corporate bonds are the most recent investment category to be hit by the negative trend. Food conglomerate Nestlé has already managed to place short-term bonds at a profit, and the same holds true for energy giant Shell.

Nevertheless, many investors, including banks and insurance companies, have no choice but to pay to park their money.

The money managers are required to hold safe investments. But they cannot simply leave money in an account, because the default risk would be too concentrated.

For security reasons, hoarding cash isn’t an option either.

Many are now turning to bonds of companies with lower credit ratings, in return for a higher risk of default. This in turn brings down the yields on those bonds, as well.

But can a downward shift in the entire interest-rate structure be a good thing?

No, said legendary investor Bill Gross.

“More and more capital is being misdirected as a result of the failed attempts by central banks to stabilize the economy,” said Mr. Gross, a fund manager at Janus Capital.

Even with bonds that are still yielding interest as a relatively default-proof investment, investors are getting back less money than they invest.

Fund manager Ralf Burmeister, a senior portfolio manager for German mortgage bonds and other international covered bonds at Deutsche Asset & Wealth Management, is a frequent member of panel discussions at conferences.

“At least it doesn’t cost me anything,” he said at a recent event, generating chuckles in the audience.

In fact, bonds have become extremely expensive for investors.

 

By the time that ECB President Mario Draghi announced in January that the central bank would buy sovereign debt worth €1.1 trillion in the next year and a half, it was clear the suction of the negative interest-rate environment would grow.

The securities backed by mortgages and public-sector loans are considered very safe – and in times of general uncertainty, safe investments have their price.

Short-term bonds issued by Deutsche Bank, Münchener Hypothekenbank, Landesbank Baden-Württemberg and Dutch bank ABN Amro are yielding just under zero percent.

This means that investors who buy the securities today and hold them until maturity will be paid out less than they invested.

In other words, they are paying to hold the bonds.

Unicredit Bank estimates that bonds worth more than €7 billion are yielding negative interest. This is only a small portion of the index for liquid securities — €730 billion listed on the respected iBoxx bond market index.

But about half of the covered bonds within the index are already approaching the zero mark, with average yields of less than 0.25 percent.

According to Unicredit, more than €270 billion in bonds from development banks, regions and supranational institutions, known as the so-called Sovereigns, Supranationals and Agencies market, are also affected by negative yields.

This is about a quarter of the market, and includes short-term securities from state development banks such as Germany’s KfW, annuity banks of supranational institutions such as the European Investment Bank, and the euro bailout funds EFSF and ESM.

As a buyer, the ECB is intervening “dramatically” in pricing, says Florian Hillenbrand, an analyst with Unicredit. And investors – banks, in particular – can do little to defend themselves.

This is because banks are required to keep government bonds, government-related bonds and covered bonds on their books as liquid investments. They are also required to back up these bonds with little or none of their own equity capital.

In other words, it makes perfectly good sense for banks to buy bonds, even those with negative yields.

Another reason is that other investments require costly capital resources.

In addition, some investment funds are only permitted to deviate slightly from indices on which they are based. For them, finding a more profitable investment is hardly an option.

For institutional investors, simply investing their money in cash instead of negative interest-rate bonds is not an alternative.

For security reasons, they would need enormously expensive safes in which to deposit the money. They would also have to revisit the difficult issue of insurance. For these reasons, money will continue to flow into safe bonds, despite negative yields.

Alberto Gallo, the head of European macro credit research at RBS, likens the bond markets to a “black hole” into which the ECB’s liquidity has been disappearing instead of going to more productive use in the real economy.

“Governments will cut spending, banks will stop lending, and business will stop investing, merely because refinancing is so attractive,” he said. Debt levels are still too high to make them change their behavior, he adds.

The pull of this black hole keeps getting stronger, now that yields on corporate bonds have also dropped to historic lows. The average yield on bonds issued by reputable companies and denominated in euros is less than 1 percent.

So far, only very short-term bonds such as those issued by Swiss food conglomerate Nestlé, which mature in about a year and a half, or bonds issued by British oil company Shell, which mature in a year, are yielding negative returns.

Still, investors expect even more negative yields among corporate bonds. James Tomlins, portfolio manager at M&G Investments, can only resort to irony, saying: “This is truly a brave new world.”

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