John Husselbee

A case for bonds – why hold a negative-yielding asset class?

John Husselbee

There has been growing chatter over recent weeks and months about negative-yielding bonds and the figures are stark: more than $17 trillion of debt is now ‘paying’ a negative yield, more than a quarter of the entire global fixed income stock.

Before looking at the ramifications of negative yields, a quick explainer of what they actually mean. In the first place, investors will not have to physically pay for lending money to a government or company, rather than receiving the interest expected from a bond. Bund investors will not have to trot to European Central bank twice a year to hand over cash; what's happening though is that the nominal value of their asset is declining over time.

Going back to basics, most bonds have a par price, say £100, and for investors loaning to a government or company, the entity in question commits to paying regular interest (the coupon) as well as returning the money in full at the end of a fixed term. As bonds trade on the open market however, the price investors pay for the bond can be higher or lower than par and so the yield will rise or fall.

As for negative yields, this is where the concept of yield to maturity comes in, which basically calculates the total value of a bond by factoring in future coupon payments and eventual return of capital at the end of the term. If the purchase price is higher than the par value plus the value of future coupons, the bond is negative yielding –if a bond pays a coupon of £1, has a price of £104 and matures in a year at £100 for example.

Negative yields are a simply a reflection of extremely high prices and in recent months, investors fleeing Brexit and trade war risk have boosted the mountain of negative-yielding bonds.

On the surface, this means many bonds have a negative nominal return: if you currently lend the German government €100 for ten years, you can expect to get back around €93 if you hold to maturity. For bond investors however, this drop in yields has generated the best year-to-date return since 1995. If nothing else, it would seem the concept of bonds as a risk-free investment needs revisiting.

While US Treasuries are a rarity in terms of positive yields for now, no less an economic guru than former Fed chair Alan Greenspan believes negative yields are a matter of when rather than if. Amid all this, Nestle recently became the first company to see its 10-year euro debt yielding below zero.

So, what can we say about bonds within a multi-asset context today? As anyone who has looked at our portfolios in recent years will attest, we have been bearish on this asset class for the best part of five years – but we continue to see a vital role for fixed income in any properly diversified multi-asset proposition.

When we look at bonds over the long term, we tend to talk about four main attributes, income, inflation protection, capital preservation and diversification, and for the most part, those remain intact. You could quibble on the capital preservation side but we would question how many investors are buying bonds for capital growth. This is an income-producing asset class first and foremost and as stated, investors will only lose money on negative-yielding bonds if they hold them to maturity.

Key for us is the diversification element and this is the core reason we have maintained a position in bonds.

As we have written in the past, diversification is a vital, but often misunderstood, part of successful multi-asset investing. Asset allocators often talk about the freedom to zero weight certain areas as a sign of their active approach but we feel this fundamentally misses the point.

If you look at period where UK equities have suffered down months over the last 20 years for example, bonds have largely produced a positive return – and this was also the case in the panic-ridden fourth quarter of 2018 where our bond positions helped offset drawdowns across our equity exposure. The negative correlation with equities is especially important in the times of distress: in flight-to-safety periods, government bonds are typically the primary beneficiaries of capital leaving stocks.

Zero weighting is not an example of diversification and while it might be uncomfortable to hold a falling asset, something else is likely to be rising at the same time: it is the overall blend that helps produce a smoother performance ride over the long term. Decades of data and portfolio theory show the benefits of diversification and we are not going to throw all that out that out just to take an asset allocation punt.

We would highlight a couple more points on negative-yielding bonds. First, while few are predicting deflation in Europe at present, government debt – whatever the yield – is among the few asset classes that should perform well if we do suffer a fall into negative prices due to its fixed coupon and principle payments.

Also, as several pundits have pointed out, there is hardly a wealth of alternative options for investors seeking lower-risk asset classes. Deposit rates from most banks are miniscule and gold, while it has its benefits, is not a large-scale option. Investors can move up the fixed income risk scale into corporates or high yield but as stated, we are already seeing negative yields creep in here and would expect to see defaults pick up to some extent if conditions worsen. Give all this, we would expect demand for government bonds to continue even if negative yields persist.

Overall, while the current concern around bonds is understandable, it also highlights the common – and not particularly helpful – trend of seeing asset classes as homogenous entities where all the underlying components behave in exactly the same way.

It is important to understand we are not ‘buying bonds’ as a multi-asset investor but rather investing with managers who we believe can generate returns from this asset class whatever the conditions. Many bond managers, particularly in the strategic space, are aware of the drawbacks of their asset class at present but confident they can continue to make money for investors, often by limiting directional exposure and finding opportunities thrown up by current conditions.

We also look at bonds from a global perspective as tends towards managers wo do the same, although we look to remove any currency risk – wanting diversified fixed income rather than FX exposure.

For a comprehensive list of common financial words and terms, see our glossary here.

 

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Monday, November 18, 2019, 5:17 PM