Capital Markets | Fixed-Income Strategy

Author: Gordon Platt
Topsy-turvy world for debt markets ensues as “zero lower bound” for interest rates disappears.

Economists used to believe there was a “zero lower bound”—that is, a bottom—for interest rates. However, investors lined up recently to pay for the privilege of lending money to Finland. The country floated a five-year note with a negative yield. The credit markets have entered an Alice in Wonderland world where corporations, like countries, may begin issuing short-term bonds with negative yields for the first time.

The outstanding bonds of Nestlé, due to mature in 2016, began trading at a negative yield in February. Government bond yields are negative across much of Northern Europe, amid fears of deflation and stresses in the eurozone.

“Despite all the talk of a US exit from quantitative easing, real [inflation-adjusted] interest rates in the US not only continue to be negative, but they are also lower than in Europe,” says Axel Merk, president and CIO at Merk Investments.

There may be no such thing as a safe investment any more when real interest rates are negative, Merk says. “Investors may want to consider a diversified approach to something as mundane as cash,” he says. “Negative rates make holding cash a losing proposition.”

In Denmark, FIH Erhvervsbank has begun charging retail customers to hold money in their deposit accounts. Other Danish banks have stopped issuing mortgage-backed bonds, not knowing how to handle negative rates on the securities.

“All that is solid is melting into air, or that’s how it feels since several central banks in Europe have adopted negative policy rates,” says Marc Chandler, global head of currency strategy at Brown Brothers Harriman. “It is not clear where the real bottom is now.”

One reason investors might buy a bond with a negative yield is that they expect the currency in which it is denominated to appreciate, Chandler says. Some investors may find buying a security with a slightly negative yield is preferable to depositing it at a rate that is even more negative, he notes.

For the first time, the German 10-year bund yield has fallen below the 10-year Japanese government bond yield.

Nearly $2 trillion of bonds in Europe and another $1.8 trillion in Japan are trading with a negative yield. Negative interest rates have never been seen on such a global coordinated basis before, says Deutsche Bank credit strategist Jim Reid.

“The problem for central bankers is that they have inflated certain asset prices to levels where, if they reined in their actions too much, then they would likely see adverse market moves and a loss of confidence in the system,” Reid and his team wrote in a recent report.

Deutsche Bank forecasts that central banks will buy more assets at the global level in 2015 than they did last year. We are still a long way from finding a sustainable financial system, it notes. 


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