Navigating the negative-yield universe [Quarterly Perspectives] - J.P. Morgan Asset Management

Navigating the negative-yield universe [Quarterly Perspectives]

Contributor Global Markets Insights Strategy Team
The ECB puts the eurozone at the centre of the story

The relentless pursuit of economic growth–and higher inflation–by central banks in recent years has driven yields to record lows across most of the developed world. Now, lack of inflation–or outright deflation in Europe–reduced investor risk appetite and de-risking from institutions such as pension funds have made the problem even worse, as shown in the chart below.

QP - Navigating the negative-yield universe - IMG1

  • The prolonged period of central bank bond buying globally has created an unprecedented demand for bonds, pushing prices higher and yields to extreme lows.
  • Measures designed to support the eurozone since 2012, such as the introduction of European banking union, have greatly reduced the perceived threat of default for many smaller economies, attracting capital flows and pushing up bond prices.
  • More recently, the sharp decline in oil prices has helped to drive inflation expectations down further. This encouraged speculative buying of sovereign European debt in the lead-up to the much-anticipated start of full-scale sovereign bond purchases–quantitative easing (QE)–by the European Central Bank (ECB) in March 2015.

As a result, the yield on German bunds is negative all the way out to a maturity of six years, and negative-yielding bonds can also be found in the French, Dutch, Austrian and Irish yield curves.

QP - Navigating the negative-yield universe - IMG2

Negative yields may be with us for some time

There are many reasons why an investor may be willing to accept a negative yield. They may prefer the safety of owning higher-quality sovereign debt regardless of the cost, while others may be forced to accept a negative yield. Regulatory changes mean that banks and insurance companies, for example, must hold higher-quality capital as a buffer against losses.

However, investors who are not constrained by regulation should only be investing in negative-yield bonds if they expect to be rewarded in some way. The question for them today is: what more can they expect in terms of total return, given how far prices have already come?

  • At these levels, the upside potential for bond prices is clearly smaller than it was. However, ECB purchases and continued low inflation could keep eurozone bond prices at these elevated levels, and even push them higher.
  • Economic momentum broadened out over the first three months of the year, but inflation and inflation expectations in Europe are likely to remain low throughout the year. The ECB’s staff forecasts are for 0% inflation this year before rising to 1.8% by 2017, but, critically, only if the full programme of QE is implemented.
  • There is every possibility that if the economy or inflation expectations do not respond in the way the ECB expects, QE will be extended. In addition, there could be a scarcity issue in certain parts of the market, since the ECB is going to be buying more sovereign debt in 2015 than European governments will be selling. This was not the case in the UK and the US when their central banks undertook QE.

QP - Navigating the negative-yield universe - IMG3

Investment implications

Yields are expected to remain low within Europe given the relatively large scale of ECB intervention this year and next. This means that investors can hope to earn positive total returns as yields are driven down from their already low levels, especially in the peripheral markets. However, the very high level of prices means that the potential rewards for holding these assets are much lower than they were–and the risks of a reversal correspondingly higher. Sooner or later, nominal and real rates will start to rise. This could cause market volatility, as well as capital losses–particularly for holders of longmaturity debt.

Diversified and flexible strategies are the best way to protect portfolios and to pursue the search for a more efficient risk/reward profile of bond investing. Investors should be ready to consider a wider range of fixed income options to put in their portfolios, including European highyield corporate bonds. Investors in these markets need to be mindful of the potential illiquidity risks in these markets and look for assets they are willing to hold for the long term. But if they can withstand future periods of volatility, these assets could offer attractive total returns compared with traditional bonds.

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