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Is “invest” the right word to describe an asset that when held to maturity guarantees a loss of capital?
Q2 hedge fund letters, conference, scoops etc
Interest rates are at historically low levels around the globe. Interest rates are negative in Japan and throughout much of Europe. In this article, we expound on the themes laid out in Negative is the New Subprime, to discuss the mechanics of negative-yielding debt as well as the current mindset of investors who invest in negative-yielding debt.
Over the past few decades, the central banks, including the Federal Reserve (Fed), have relied increasingly on interest rates to help modify economic growth. Interest rate management is their tool of choice because it can be effective and because central banks regulate the supply of money, which directly affects borrowing costs. Lower interest rates incentivize borrowers to take on debt and consume while dis-incentivizing savings.
Regrettably, a growing consequence of favoring lower-than-normal interest rates for prolonged periods is that consumers, companies and nations grow increasingly indebted as a percentage of their respective income. In many cases, consumption is pulled from the future to the present day. Accordingly, less consumption is projected for the future and a larger portion of income and wealth must be devoted to servicing the accumulated debt as opposed to productive ventures that would otherwise generate income to help pay off the debt.
Negative yield mechanics
It’ not only sovereign debt; investment-grade and even some junk-rated debt in Europe now carry negative yields. Even stranger, Market Watch just wrote about a Danish bank offering consumers’ negative interest rate mortgages.
You might be thinking, “Wow, I can take out a negative interest rate loan, receive payments every month or quarter and then pay back what was lent to me?” That is not how it works, at least not yet. Below are two examples that walk through the lender and borrower cash flows for negative-yielding debt.
Some of the bonds trading at negative yields were issued when yields were positive and therefore have coupon payments. For example, in August of 2018, Germany issued a 30-year bond with a coupon of 1.25%. The price of the bond is currently $143, making the yield to maturity -0.19%. Today, it will cost you $14,300 to buy $10,000 face value of the bond. Going forward, you will receive coupon payments of $125 a year and ultimately receive $10,000 in 2048. Over the next 29 years you will receive $3,625 in coupon payments but lose $4,300 in principal, hence the current negative yield-to-maturity.
Bonds issued with a zero coupon with negative yields are similar in concept, but the mechanics are slightly different than our positive coupon example from above. Germany issued a 10-year bond which pays no coupon. Currently, the price is 106.76, meaning it will cost an investor $10,676 to buy $10,000 face value of the bond. Over the next ten years the investor will receive no coupon payments, and at the end of the term they will receive $10,000, resulting in a $676 loss. The lower the negative yield-to-maturity, the higher premium to par and the greater loss of principal at maturity.
Example two, the zero-coupon bond issued at a price above par, will be the issuance model going forward for negative yielding bonds.
Why?
At this point, after reviewing the cash flows on the German bonds, you are probably asking why an investor would make an investment in which they are almost guaranteed to lose money. There are two predominant reasons worth exploring.
Safety
Investors who store physical gold in a gold vault pay a fee for safe storage. Individuals with expensive jewelry or other keepsakes pay banks a fee to use their vaults. Custodians, such as Fidelity or Schwab, are paid fees for the safekeeping of our stocks and bonds.
Storing money, as a deposit in a bank, is a little different from the prior examples. While banks are a safer place to store money than a personal vault, mattress or wallet, the fact is that deposits are loans to the bank. Banks traditionally pay depositors an interest rate so that they have funds they can lend to borrowers at higher rates than the rate incurred on the deposit.
With rates negative in Europe and Japan, their respective central banks have essentially made the storing of deposits with banks akin to the storage of gold, jewelry, and stocks – they are subject to a safe storage fee. Unfortunately, many people and corporations have no choice but to store their money in negative-yielding instruments and must lend money to a bank and pay a “storage fee.”
On a real-return basis, adjusted for inflation, whether an investor comes out ahead by lending in a negative interest rate environment depends on changes to the cost of living during that time frame. Negative yielding bonds emphatically signal that Germany will be in deflation over the next 10 years. With global central bankers taking every possible step, legal and otherwise, to avoid deflation and generate inflation, betting on deflation via negative yielding instruments seems like a poor choice for investors.
Read the full article here by Michael Lebowitz, Advisor Perspectives
