In 2011 someone asked me what assets I thought were over-priced. I am too much of an efficient markets adherent to say anything is overpriced, but I speculated people were paying an awful lot for safety. I was talking about government and other highly rated bonds, which are considered by many to be “risk-free” assets. At the time they were offering historically low yields.
How wrong I was! Or, I was right at the wrong time. Since then not only have yields continued to fall but nine European countries are offering a 10-year bonds with a negative yield. That is, bond holders are paying for the right to own the security. Globally, negative yielding debt now totals $13.4 trillion. But now, in an even more surprising twist, junk, or high-yield, bonds—traditionally risker assets—are offering negative yields. Fourteen companies in Europe rated BB or less are being paid to borrow investors money. And buying these bonds may even be a good bet—for now.
Why are yields so low?
Historically, high-yielding corporate bonds in Europe offered a good return, but since the Great Recession of 2008, yields have been trending down to levels once only offered by highly rated government-issued bonds.
Corporate bond yields rise and fall for three reasons: The riskless rate, which is the yield from short-term highly rated government bonds; the risk premium, which compensates investors for the chance of a default; and price volatility, because if the market gets dicey, high yielding corporates can be hard to sell. The risk premium—the difference in yield between high-yield and risk-free yields—has fallen a bit in the last few months, but it has been fairly stable the last five years.
To a large extent, the low rates simply reflect that the yields on risk-free assets have fallen and they took down the whole bond market with it. Tim Winstone, a fixed-income portfolio manager at Janus Henderson told the Wall Street Journal, “Investment grade is nuts, about 24% of my benchmark yields less than zero.” There seems to be some reach for yield, when investors can’t afford the price of low risk and are willing to make a riskier investment to get a higher return, even if it’s still negative. More demand for high risk bonds means lower rates.
Why would any one buy these bonds?
About 2% of European high-yield bonds are offering negative yields, and it seems crazy there are that many. By definition, junk bonds pose more risks, so why take a negative yield for a risky asset when you can buy stocks or just keep that money in cash? Risk is relative, however, and if you have lots of cash, like many corporations do, having a vault of physical cash is not feasible. You must invest it somewhere, and there are no low-risk options that offer a positive return. The euro deposit rate is -0.4%, meaning depositing money in the bank costs investors more than high-yield bonds, which are at about -0.2%. Government and high-grade corporate bonds cost even more. The stock market may sound more appealing, but it offers less certainty (at least in the short-run) since it promises no fixed payments.
Some of the yields aren’t as negative as they look because some of the junk bonds are callable, which means investors pay a little less to compensate them for the possibility the borrower will pay the loan back early. If the borrowers don’t call the bonds, the investors might come out ahead, at least compared to any alternative. Many of the negative yielding bonds have a short duration, only about one or two years, so the odds of a default or spike in yields (with the European Central Bank hinting at a rate cut) in that time span are pretty low. In fact, if the ECB does cut rates, more junk bond yields might turn negative, or go even further negative, in which case the bond buyers can earn a profit.
Is this a sign something is wrong?
Perhaps not. Bond yields are market prices and this is the current price for bonds. But could be it a bubble, or are the prices somehow wrong and due to crash? Maybe, but given the information in markets now, including the likelihood of central bank rate cuts in the US and Europe, the prices may reflect the best possible information from an efficient markets perspective. But there are reasons to worry: Risk premiums often aren’t stable and can rise fast at the first whiff of trouble. When that happens, rates will rise too or the market might become illiquid and bond holders will lose money and can’t sell their debt. Central banks and the IMF often warn of companies with poor credit taking on high levels of debt as a source of systematic vulnerability. If yields do rise quickly, the market could freeze and already leveraged companies may not be able to raise more debt—creating a vicious cycle in the corporate bond market, where yields rise even higher, but with few investors interested in buying risky bonds. Corporate defaults could follow and even retail investors in bond funds will take a loss.
But if you believe, as many policy makers and economists do, that interest rates are permanently lower because of globalization and demographics, then you’d expect even riskier loans to offer lower yields too. But even if that’s true, risk premiums are unpredictable and can change without warning. Buying junk bonds is always risky.