- Negative-yielding corporate debt recently passed $1 trillion in market value.
- Investors holding the bonds for price appreciation face significant risk should rates start to rise, says Jim Bianco of Bianco Research.
- “The financial system doesn’t work with negative rates. If the economy recovers, the losses that investors would take are unlike anything they’ve ever seen,” he says.
Government bonds aren’t the only instruments producing negative yields these days, with corporate debt recently passing the $1 trillion mark in a continuing sign of global financial displacement.
Investors these days are facing huge amounts of fixed income instruments that carry no yield. Various estimates of sovereign debt in that category put the total in excess of $15 trillion, a number that has been escalating over the past several years while central banks drive interest rates to zero and below.
Negative-yielding corporate debt, though, is a relatively new thing, rising from just $20 billion in January to pass the $1 trillion mark recently, according to Jim Bianco, founder of Bianco Research.
The trend poses a potentially dangerous threat, especially if market winds shift and bond holders looking for price gains rather than yield get stuck holding too much risk.
“The interest rate risk that these bonds carry is huge,” Bianco said in a recent interview. “The financial system doesn’t work with negative rates. If the economy recovers, the losses that investors would take are unlike anything they’ve ever seen.”
Negative yields have been confined to places outside the U.S., though some Federal Reserve officials have toyed with the idea at least in a hypothetical sense. Former Fed Chairman Alan Greenspan recently jolted some investors when he said there was nothing actually standing in the way of negative U.S. rates.
Most of the negative-yielding corporate debt is in Switzerland, while some also is in Japan, Bianco said.
Investors don’t actually pay to borrow money, but the negative yield is symbolic of how much above par investors are willing to pay for these bonds.
That’s because those who buy negative-yielding bonds are essentially making a bet that rates will stay low and prices will rise, which is the traditional relationship when it comes to fixed income. Should rates start to rise even a little, that will start to eat into the capital appreciation that bond holders have been enjoying.
For instance, Bianco said, if yields on Swiss bonds go up just 2 percentage points, it would amount to a 50% loss for holders. While some individual investors might be able to absorb such losses, they would be catastrophic for institutions.
‘A wall of new money’
On the sovereign side, Germany is the starkest example of negative rates, with yields all along the curve there trading below zero. That has pushed prices up dramatically. In Tuesday trading, buyers were paying the equivalent of $195.87 for every $100 in 20-year German bunds, all for a technical yield of minus-0.386%.
Bianco attributes the negative-yield trend to entities including the European Central Bank pumping money into the financial system and pulling investors along for the ride.
“They’ve so flooded their financial system with money that there’s not enough alternatives,” he said. “That’s why you have people paying such astronomical prices that you wind up with negative yields.”
On the corporate side, the picture isn’t much prettier outside the U.S.
The $27.8 trillion of non-U.S. dollar investment grade global debt is collectively yielding just 0.11%, according to Hans Mikkelsen, credit strategist at Bank of America Merrill Lynch. Of all global investment grade debt delivering any yield, 95% is from the U.S.
“We continue to think there is a wall of new money being forced into the global corporate bond market,” Mikkelsen said in a recent note to clients. “The trigger is lower interest rate volatility or simply the passage of time, as a lot of foreign investors are being charged (negative yields) for being underinvested.”
Mikkelsen said there’s investment opportunity at the front and back ends of the yield curve. Investors worried more about recession should be taking on U.S. investment grade debt with short duration, while those more confidence in the economy should focus on longer-term instruments. He said he prefers investments “out the curve” as he sees recession probability lower than what is currently being priced in.
U.S. credit quality remains good, despite the influx of corporate bonds into the market.
Nonfinancial business debt was at $6.4 trillion at the end of the first quarter, a 73% increase from mid-2009 when the current expansion began. However, as a portion of equity it’s only 33.7%, from its recession peak of 69% in early 2009.
Covenant protections, or the buffers investors demand in case of default, are at record lows, according to Moody’s Investors Service. However, default rates are projected to remain low — 2.9% for the year ahead, compared with the long-term average of 4.7%.