Susan Buckley has had a long and distinguished career as a bond investor. But the head of fixed income at the $78 billion Brisbane-based fund QIC is still getting her head around the unthinkable developments in global bond markets.
“It does require a mind-shift change, and in my 30 year career I never thought we would get to this point,” she says, before making a confession. “But yes, we have bought a negative yielding bond in expectation of greater capital gain.”
To say we’re in unfamiliar bond market territory is an understatement. What is going on in interest rate markets is downright bizarre, with over $US 10 trillion of government issued bonds paying rates of interest that are below zero. A recent QIC paper on the subject of negative interest rates references the Wizard of Oz, noting “We’re not in Kansas anymore”.
This is a world where safety comes at a cost to the point where investors are effectively paying governments to fund them as central banks in Europe and Japan drop policy rates into negative territory to spur spending.
But negative rates actually mean positive returns for bonds, with rates that were set in positive times, or even less negative times (remember bond prices rise as yields fall).
The lower the interest rate, the more sensitive the price of the bond is to movements. For instance, a 30-year bond paying 3 per cent, could rise or fall in price by more than 20 per cent if rates moved just by one per cent.
German government bonds which have had average negative yields of -0.33 per cent and Japanese government bonds with an average yield of -0.18 per cent are strange enough. But investors in German bonds have gained 6.55 per cent since the start of the year, while Japanese bonds have returned 8.26 per cent.
As QIC director Katrina King points out, this is a strange world where investors “buy bonds for capital gains and equity for income – it should be the other way around”.
For bond investors such as QIC, the reality that negative interest rates are here to stay is setting in. Interest rates in Australia may be positive but they cannot escape its consequences.
One of the most obvious is on the global bond benchmarks that investment funds are evaluated against. The Citi World Government Bond index currently has 42 per cent of securities trading with a negative interest rate, a further 10 per cent yielding 0 to 1 per cent and just a small fraction of bonds from Australia and the emerging markets paying more than 2 per cent.
As yields have sunk further into negative territory, existing bonds with less negative rates have become more valuable, resulting in healthy gains for insurance companies, pension funds and other holders of government debt.
But they will face problems in the future as they are given new funds to invest and as they buy longer-term bonds they’re taking on more interest rate risk to achieve positive returns.
‘History will remember this badly’
In the non-financial world, there are serious doubts about how effective these negative interest rate policies have been in boosting economic output.
King believes “history will remember this badly”. She points out that the evidence in Sweden Switzerland and Denmark has been that after a certain point the costs outweigh the benefits. Banks can no longer wear the costs of paying the central bank for excess deposits while savers are compelled to put their money in safes, under mattresses and even in their microwaves.
The Swedes, which have embraced a cashless economy, are now paying the price as their deposit accounts are eroded by negative rates. Other central banks with positive policy rates such as the Federal Reserve and the Reserve Bank of Australia have watched the negative rate experiment and have concluded it’s not something they want to do.
The next frontier of monetary policy wackiness is “helicopter money”. Debate continues on whether it applies to fiscal stimulus or direct financing of government spending by the central bank. The origin of the term stems from a thought experiment economist Milton Friedman in which $1000 bills are dropped from the sky to wilful recipients on the ground.
But as central banks explore new tools to stoke inflation, versions of free money have been debated as serious, viable and essential policy options.
King defines helicopter money as “making a connection between the central banks and government spending” where governments simply create money to spend. She believes that a more likely development is a rebooting of non-central bank financed government spending “to get economies moving again” as monetary policy options max out.
If this occurs, say in the United States, it could allow the Federal Reserve to hike interest rates without causing too much unease in financial markets. That could mark the turning point of a relentless fall in bond rates since the global financial crisis.
“We have moved to an obsession with austerity and debt costs to thinking more longer term and talking about fiscal expansions and other arms of policy,” says Buckley.
In Australia, we’ve been fortunate to avoid negative interest rates even though long term bond rates are way lower than they’ve ever been before. Australia’s 10-year rate currently sit below 2 per cent – which in global developed bond terms makes it a super high yielder.
With offshore funds seeking solace from negative rates in Australia offshore buyers are flooding into government, semi government and corporate bonds pushing up the currency again.
“There still seems to be downward pressure on yields – we have another one or two rate cuts [as our base case]. It’s a market we would be prepared to be long,” Buckley says.
As for the rest of the global bond market it’s mind-bendingly difficult for investors to accept that buying negative yielding Japanese and German government bonds is a good way to protect investor capital. Investing in fixed income, she says has to be completely “redefined” as rates fall and markets become more difficult to trade.
“We have to be careful the boy who cried wolf,” Buckley says acknowledging that previous warnings that ultra low bond rates would revert to more normal levels have not eventuated. But as rates dip even further below the zero bound, the risks are on the rise.