A requiem for negative government bond yields

AS BURSTS OF INFLATION and as central banks begin to reverse the ultra-loose monetary policies that have defined the past 14 years in financial markets, one of the most striking signs of the cheap money era is fading. The pool of negative yielding bonds evaporates.

Less than three years ago, no less than 40% of global public debt offered negative yields. Today, this share has fallen below 10%. Much of it is concentrated in very short-term European and Japanese debt, the former of which is not long for this world, if market expectations of higher interest rates in the eurozone are to be believed. The volume of negative yielding corporate bonds, a particularly striking feature of recent financial history, is close to zero.

It may seem strange, in this context, to say that the years to come will still be marked by investors in search of yield. But if the past decade has been characterized by a desperate search for nominal returns, an equally frenzied rush for real income seems likely to ensue.

Negative yields have changed investor habits less than feared in 2016, when oil prices fell and German and Japanese ten-year bond yields initially fell below zero. Conservative investors — reserve managers and pension funds, for example, with tens of trillions of dollars to deploy — have always bought bonds. Mass hoarding of physical cash, which offers a nominal interest rate of zero, has not happened. This is largely because stubbornly low inflation has changed real returns relatively little. And for most investors, actual returns, that is, the ability to protect and increase the value of a pot of capital, is what matters.

The road ahead looks at least as bumpy for investors looking for real returns as the one behind it, if not more difficult. While expectations for higher interest rates have risen, the ten-year Treasury yield, at 2.8%, is higher than it was for nine tenths of the time of the past decade. The yield on inflation-protected Treasury bonds is always around zero. This is higher than it was for most of the pandemic, but barely above its level during the 2016 deflationary swing. Since 2012, real yields have been higher around the two-thirds of the time.

The situation in the euro zone is even more extreme. Real yields on long-term government bonds are much lower than they were at the height of the deflation panic. A German inflation-linked bond maturing in 2046 now offers a yield of -1.6%, compared to -0.8% in mid-2016. A modest rise in interest rate expectations was overwhelmed by the larger jump in expected inflation.

What does this change in regime mean for traditional portfolios, balanced between equities and bonds? When nominal yields on newly purchased bonds fell and inflation was low, investors at least saw the benefit of capital gains on their existing holdings (bond prices move inversely to yields). Now, bond investors must experience both negative real returns on newly purchased bonds and a decline in the value of their stock of holdings.

Some assets, such as high-yield US corporate bonds and some emerging market corporate debt, benefited from investors’ initial search for yield. Recent developments in financial conditions complicate their outlook. High yield bonds, for example, are more likely to offer positive real returns. But rising interest rates and the higher possibility of recession also make these assets riskier. Some emerging market bonds could gain favor: China is one of the few countries where real short-term interest rates are positive; Brazil, Mexico and South Korea are issuing inflation-linked debt with yields in positive territory. But currency hedging could eat up the entire return.

Public and private market equities, and underlying assets whose returns are linked in some way to nominal economic growth, rather than just interest rates, may be more attractive. Assets that have some price power, such as rental properties and investments in commodities and infrastructure, are also likely to be favoured.

Even as nominal bond yields see their most dramatic increases in a generation, the picture of real yields will remain familiar to investors aware of the pressures of the past decade. Unless the world’s major central banks become radically more hawkish about inflation and engineer an economic downturn – just as then-Federal Reserve Chairman Paul Volcker did in the 1980s – the real income rush could prove to be a decisive force in the markets.

Read more from Buttonwood, our financial markets columnist:
The Complicated Politics of Crypto and the Web3 (April 16)
Bonds are signaling a recession. Actions were dynamic. Which give? (April 9)
Can the Fed achieve “perfect disinflation”? (April 2)

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