In a report “Making Sense of Negative Yields,” a Morgan Stanley report explains why institutional investors in Europe are purchasing bonds that pay the corporation rather than the investor AKA Negative Yielding Bonds. “With valuations as distorted as they are, investors are left with very small margins for error,” the September 12 report warned. The report “plunge(d) further down the rabbit hole and explore(d) this new upside-down world of European corporate credit.”
Negative Yielding Bonds – Institutional investors driven by mandate, price momentum and benchmarks to invest
With an estimated €467 billion bonds across Europe now in negative yields – a diverse basket across issuers, maturities and credit ratings – are negative for a single reason. “ECB purchases have been the primary catalyst behind these distortions,” the report from Morgan Stanley analysts Srikanth Sankaran, Max Blass and Aron Becker stated.
Ever since the European Central Bank’s corporate sector purchase program (CSPP) began purchasing not only government debt, but corporate debt of from a variety of regional companies, the interest rates now have investors paying the bond issuers rather than receiving payments. “Clearly, we are in unchartered territory, with investors willing to ‘pay’ corporates for the privilege of lending to them,” the report said.
Why invest in bonds with a guaranteed negative return on investment?
“While paying to lend to corporates is far from normal, mandate-constrained investors do not have much choice,” the report said. Investors are being forced by their investing mandate to pay corporates for the pleasure of lending them money. “Most have to pay at least 40 (basis points) to hold cash and it costs more to lend to governments. Switching costs and benchmark considerations also feed into investment decisions on negative-yielding assets.”
Other investors are piling into negative yielding bonds because they are part of their benchmark indexes upon which performance is compared.
With investors pushed into negative rates, how does one go about making investment decisions?
Negative Yielding Bonds – Look at yield curve convexity when making a decision, as core countries and companies get the best deals
One important consideration for negative yielding bond investors is to watch convexity, or the curvature of the bond yield across time horizons.
“Spreads show a clear tendency to plateau after a corporate bond starts trading below 0% yield, indicating that excess return potential of these bonds is limited,” the report noted. “we argue that duration risk in negative-yielders is skewed to the downside. Investors should remain vigilant and reduce exposure to credits with poor convexity profiles.”
For investors, in part the motivation for a inverted yield can be a momentum play. “The irony of ongoing market distortions is that the investment case for fixed income assets has relied less on ‘income’ and more on capital gains,” Morgan Stanley noted. “Negative yields do not imply negative returns.” In fact, those who invested in negative yielding bonds throughout 2016 have generated returns. “This is the lesson from the rates market, where despite yields being in negative territory throughout the year, roll-down and yield compression have resulted in respectable returns.”
The skew in negative yields is towards core countries among larger name firm, with companies such as BMW, Electricite de France, Daimler, Shell and Siemens all on the list of those offering investors negatively yielding bonds. Some corporates offering bonds in the region such as Nestle and Procter & Gamble offer negative yields for as much as six years out on the curve.
Those corporations benefiting from less than positive yields are mostly weighted towards the AA credit ratings, with “much of this skew actually comes from financial names,” the report said. Among non-financial stock sectors, the BBB ratings category is also highly represented. “The CSPP is an important driver here, as the majority of BBB credits with sub-zero yields are eligible for ECB purchases.”