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From High Yield to No Yield
08 Oct 2019

Government bond rates trading at sub-zero levels, seem to be the new norm and it can all be traced back to ultra-loose monetary policy stances by major central banks, including the Bank of Japan and the European Central Bank. By the end of August 2019, the global value of negative-yielding debt had surpassed the €15 trillion mark, meaning that investors who acquire the debt, and hold it until maturity are guaranteed to make a loss. In comparison, two decades ago, about half of the global bond market yielded at least 5%, whereas nowadays that portion has dropped to a mere 3%.

Historically, high-yielding corporate bonds offered investors a chance to enhance their income streams, if they were willing to accept the increased level of risk. However, since the aftermath of the great financial crisis of 2008, yields on high risk bonds have been trending down to levels once offered by highly rated government bonds. Driven by fears of an economic slowdown, a world-wide bond rally has benefited investors whilst dragging down yields on both government and corporate bonds to record lows. This has left investors scouring the investment universe for ways to generate future income. By June 2019, as Mario Draghi contemplated cutting rates further, or even restarting quantitative easing, fourteen European high-yield issuers such as Altice, Smurfit Kappa and Nokia, traded at negative yields. Bonds issued by the Republic of Cyprus, currently rated on the final notch of investment grade, trade at negative yields at least up to a five year duration.

By definition, high yield bonds sometimes also referred to as “junk”,  pose higher risk when compared to their better-rated counterparts. Is it normal for an investor to accept negative yields for a risky asset when this can be substituted with equities or cash? The answer to this is two-fold: Firstly investors may be willing to accept a loss on their investments because they need reliability and liquidity which governments and large corporations  can provide through high quality bonds. Secondly, when looking at the bigger picture, markets are characterised by institutional investors  with piles of cash which cannot be stored physically and have to be invested. With a European Central bank deposit rate of -0.5%, investors might be pushed towards accepting a lesser evil and invest in non-investment grade  assets because of their lowest negative impact.

So why not invest in equities? The equity market may look more appealing, but due to its high risk attributes, lack of certainty (at least in the short term)  and no fixed income payments it may not be appropriate for all and sundry. In view of this type of buying behaviour, one might expect more volatility as buyers, who are now paying cash flow instead of receiving interest, try to exit their positions as quickly as possible.

One may argue that something may be off within the fixed income market, and that a bubble may be on its way. The bond market is in this situation due to elongated periods of monetary easing and a higher likelihood of global central bank rate cuts. There again, this does not mean that there is no cause for concern. In the current scenario, a slight hint of trouble would lead to a correction in bond risk premiums. When this happens, rates will follow suit and possibly cause the market to become illiquid with bond holders unable to sell their positions. The low yield scenario has enabled companies with poor credit to take on higher levels of debt, further exacerbating market risk when yield eventually move up again.

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