In some parts of the world, bonds are yielding less than zero. Hany Saad explains how that can happen, what it means for your portfolio and moves to consider.
Global interest rates have seesawed in 2019. At the start of the year, most investors expected higher interest rates, only to see them decline on weak economic data and dovish signals from the U.S. Federal Reserve. The Fed actually cut rates at the end of July, and the market believes they’re not done yet.
How low can yields go? While yields in the U.S. are still positive, there are now approximately $15 trillion in government bonds trading with negative yields — that’s over 27% of all such bonds issued globally. The degree varies by market. In Germany, negative yields run across the entire yield curve, from 0 to 30 years, while in Japan it’s largely the short-end that’s affected.
How do negative-yielding bonds work?
Negative yields may sound counter-intuitive, since bonds typically pay a coupon (a set interest rate) on the principal investment. In fact, in uncertain markets, investors in government bonds may be willing to accept lower proceeds in exchange for a sense of safety compared with riskier securities.
Investors don’t physically pay the issuer when yields are negative. Instead, the bond’s new issue price trades at a high premium to par, which results in a negative yield. For example, in May, the German government issued a 2-year bond with a 0% coupon and an issue price of €101.33. Over the course of the bond’s life it will not distribute any coupons payments but will payout a final maturity of €100. Consequently, this bond has a yield of -0.65% at issuance because an investor paid €101.33 to receive €100 two years later.
It is also possible for corporate bonds to have negative yields because they are issued with a “spread” over similar-maturity government bonds. In a simplified example, if a corporate bond has a spread of 0.5% over a similar maturity government bond that yields 1.5%, then the corporate bond’s total yield will be about 2.0%. That means if the yield of a government bond is more negative than the corporate bond’s positive spread, it could drag the corporate bond’s yield below zero as well.
Do U.S. investors have to worry about negative yields?
With rate cuts on the horizon, bond yields may continue to fall. While the U.S. Treasury has indicated that it does not wish to issue negatively yielding securities, the possibility of market yields falling below zero can never be completely ruled out. However, even during the depths of the financial crisis the Fed never cut the Fed Funds rate below zero, instead holding the line at 0%-0.25%.
Furthermore, current overnight U.S. interest rates are 2.00% to 2.25%, so yields are firmly in positive territory. In contrast the European Central Bank (ECB) has their current overnight rate at -0.40%.
How to navigate negative (and low) yields
For U.S. investors, the challenge is less about negative yields than low yields. Across regions and asset classes, bond yields are significantly lower than they were before the start of the global financial crisis.
While opportunities are less plentiful, however, there are still some options for bond investors if they get selective. Below are three strategies to consider, using bond exchange traded funds (ETFs).
1) Focus on U.S. markets
While U.S. bond yields are low, they are currently yielding more than other developed markets and continue to offer a ballast to equities.
2) Seek income in high yield and emerging markets
In a low-interest-rate environment, yield will be a more important component of total return. For those with some risk tolerance, bonds with more credit risk can potentially boost income.
3) Ride the global wave down with international bonds
Investors who believe that yields will continue to fall, especially outside the U.S., can look to international bonds for potential price appreciation. (As bond yields fall, their prices increase.
Investing involves risks, including possible loss of principal.
Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities. There may be less information on the financial condition of municipal issuers than for public corporations. The market for municipal bonds may be less liquid than for taxable bonds. Some investors may be subject to federal or state income taxes or the Alternative Minimum Tax (AMT). Capital gains distributions, if any, are taxable.
International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/developing markets and in concentrations of single countries.
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