Some of the world’s top asset owners have been piling into fixed income in an effort to avoid the volatility of global equity markets. But the benefits of that pivot are being withered away by the growing impact of negative interest rates.
Debt yields on sovereign paper issued by European countries including Sweden, Germany, France, Japan, Austria, Denmark, Finland, Netherlands and Switzerland have recently turned negative. About one-fourth of the world’s bonds carry negative yields, according to Deutsche Bank Securities. It estimated that the market value of negative-yielding bonds has jumped to a new record of $12.5 trillion.
“We are in a little bit of uncharted territory,” said Christian Stracke, who heads credit research for Pimco, the world’s biggest bond investments manager.
Negative interest rates first caught global investor attention in 2014, when the European Central Bank decided to pay negative rates to commercial banks for deposits held with it. The Bank of Japan followed, taking the experiment further by buying bonds and stocks.
The monetary accommodation of central banks has been in response to a lack of inflation, unlike previous cycles when it was to rectify worsening economic conditions, said Stracke. This has led to spreads tightening between sovereign and corporate debt, or the premium demanded by investors to hold debt other than benchmark US Treasuries.
In the investment-grade market, the average spread of the Morningstar Corporate Bond Index (the research firm's proxy for the investment-grade corporate bond market) tightened by 4 basis points (bp) over comparable Treasuries to 111bp last week, its tightest level since October 2018, according to David Sekera, managing director of corporate credit ratings and research for Morningstar Credit Ratings. In the high-yield market, the ICE BofAML High Yield Master II Index narrowed 18bp to 389bp last week.
Low or negative interest rates on sovereign paper often push institutional investors that require a minimum investment return towards buying corporate credit. This sends the prices of these assets higher, while lowering their yields.
“It raises a question of could you have spreads tighten even further as this continues,” he noted.
ASSET BALANCE PROBLEMS
Asset owners typically hold a large chunk of sovereign debt in their fixed-income portfolio as for stability, to counterbalance volatile equity investments or high-yielding but risky alternatives.
However this portfolio construct means the asset owners need to squeeze more returns out of their corporate credit and alternative investments to offset low or negative-returning debt, while hoping that equity investments also offer positive returns .
But equity investments failed to perform last year and going heavy on the asset class hasn’t been an option for most asset owners this year. Some pulled back on their investments this year, as market volatility forced them to record mark-to-market losses under new accounting rules.
In addition, ongoing trade tensions between the US and China have weighed on global economic growth. There were also fears at the start of the year that the Federal Reserve would act sooner to normalise rates in the wake of a fiscal stimulus that risked overheating the US economy.
The combination caused prominent asset owners to suffer. Japan’s Government Pension Investment Fund realised an investment loss greater than the GDP of Ukraine in the final three months of 2018, which GPIF president Norihiro Takahashi blamed on investors avoiding risks, revenue decline at companies and the yen’s strength among other reasons. For the full 2018-2019 fiscal year ending in March, GPIF gained only 1.5% in investment returns.
A similar fate befell Singapore’s Temasek which reported a one-year total shareholder return of 1.49% for 2018, well below the 12.19% gain it made the year before.
Asset owners have tried to respond by adding to their alternative investments. But these have offered their own risks, most recently including fears about the lack of liquidity in private assets. Meanwhile the only decent yields to be found in debt are among high yield corporate bonds or low rated sovereign debt. However, the risks of both types of debt are likely to make risk managers of asset owners queasy amid the general geopolitical tensions in the world.
Asset owners and fund managers are responding to these increasingly difficuilt positions in a number of ways, as they seek to reach minimum investment return targets.
Some fixed-income managers to buy bonds from countries that they might typically avoid. Pimco and Manulife, for example, added to their exposure of Columbian peso bonds in the last quarter, according to data compiled by Bloomberg. The two are the largest reported holders of the nation’s local debt.
However, for asset owners with a less-cast iron stomach, US sovereign debt still offers better returns (in terms of yields) than that of most developed countries. Benchmark 10-year US Treasuries were yielding 2.07% on an annualised basis on July 30 versus a negative 40bp for similar dated German bunds. Annualised yields on 10-year Swiss, Dutch and French bonds were at -0.78%, -0.29% and -0.14% respectively. It is not surprising see the fixed-income portfolios of most global asset owners tilting heavily in favour of Treasuries.
“We suggest designating a portion of fixed-income assets to Treasuries as a hedge against deflation, with the capital preservation portion of a portfolio dependant on T-bills instead of broadly diversified money market funds,” said Gautam Dhingra and Christopher J. Olson, portfolio managers at High Pointe Capital Management.
They added that investors would be well advised to be wary of investing in bonds from heavily indebted corporates, unless valuations are very compelling. “A business that relies on the mercy of the central banks is not an advisable one to own.”
One likely response from asset owners? A race to snap up more assets in the private credit space, as banks and other financial institutions move out due to the constraints from incoming IFRS 9 and CECL (an equivalent under US GAAP) accounting rules. Pimco’s Stracke said there has been interest among Asian insurers for more quality parts of high yield and bank loan market, particularly in the US.
Plus more investors may need to gird themselves and bring in more junk bonds.
“We think [US corporates with ratings in the] single-Bs are in a good place, given their moderate exposure to both interest rate and credit risk,” said analysts at Bank of America Merrill Lynch.