Europe’s festering economic crisis has turned the bond world upside down.
Debtors are actually supposed to pay investors interest, not the other way around. But since June of last year, the yields of short-term government bonds worth €1.3 trillion, or $1.47 billion, turned negative in the euro zone.
Those especially affected are bonds from Germany, France, the Netherlands, Belgium, Finland and Austria. Essentially, investors are paying to park their money with euro zone countries with good creditworthiness.
The Royal Bank of Scotland has calculated that the pool of bonds already offering negative yields, or yields of less than 0.1 percent, is likely to grow.
“The yields could fall further, so in the foreseeable future we could have more than €1.6 trillion euro government bonds with negative yields,” said Alberto Gallo, head analyst at RBS.
That would be mean more than a quarter of the outstanding government bonds in the euro zone are seeing negative yields.
That may sound shocking, but according to experts, the explanation can be found at the European Central Bank. Since June of last year, the ECB has been charging banks that deposit their excess reserves with the central bank. The ECB lowered its interest rate for such bank deposits to -0.2 percent. Since then, these negative rates have been eating through the bond market.
And that’s exactly what the central bankers surrounding ECB President Mario Draghi want.
Banks must support their dealings and investments with equity. However, that does not apply to bonds from the euro zone countries
With the penalty interest, Mr. Draghi wants to encourage banks not to park their money at the ECB, but to lend more to businesses or to invest in the markets instead. In other words, to boost the economy.
The ECB’s recently announced government bond purchasing program will contribute to this. Starting in March, the ECB will begin buying up at least €1.14 trillion in bonds over a period of at least 19 months. The lion’s share will be government bonds. That could push bond prices up and push yields down even further.
“What is expensive, could become more expensive,” is the pithy take on it by strategists at the Société Générale, a French bank.
So why are investors still buying? For one thing, even a negative yield can be good for speculators. Falling yields means the price of buying bonds is rising. Most speculators don't hold bonds to maturity - they merely buy the bonds at one price and sell the bonds again at a higher price.
But such speculation is only part of what is driving institutional investors to continue purchasing securities with negative yields. It may seem like bad business sense to pay someone to lend them money, but for many financial institutions, buying the safest of assets on the market is a necessary part of their business model - regardless of the payback.
Many banks are indirectly compelled through regulatory requirements to purchase government bonds - even those at negative interest can pay off. Insurers must also buy many bonds for regulatory reasons, though they avoid securities with negative yields. Some investment funds, on the other hand, are less able to avoid government bonds with negative yields, as their investment decisions are linked to corresponding bond-oriented benchmark indexes.
“With us, bonds with negative yields are primarily in the passive segment, or in exchange-traded funds,” said Michael Krautzberger, head of the Euro Fixed Income team at BlackRock. “With actively managed annuity funds, if need be we concentrate our efforts on those bonds with negative yields where we expect the rates will continue to rise.”
According to Mr. Krautzberger, BlackRock's actively managed funds are primarily targeting German government bonds with longer maturities. The yields of 10-year German government bonds are historically low, but at 0.35 percent are still in the positive realm. Many funds do not hold German government bonds just for their yields, but also because they are very liquid (can be bought and sold quickly), allowing them to potentially make money quickly and with low margins. That should also drive some funds to buy bonds even with negative yields.
Banks must look into where they will lose the least. Alberto Gallo, head analyst, RBS
At the banks, the motivations for holding bonds - even negative ones - are more obvious. While banks are required by regulators to set capital aside for most of their business dealings and investments, this is not the case with euro zone government bonds - even the most controversial ones.
“Because of these regulations, it makes sense for the banks to buy even government bonds with slightly negative yields, because the investment alternatives require holding more expensive equity,” explained Christian Götz, a strategist at the Landesbank Baden-Württemberg, a regional German lender.
In addition to that is the so-called liquidity coverage ratio, a new benchmark that took effect in October and which requires banks to keep enough of their business in liquid assets that could be freed up in time of crisis. Regulators count euro zone government bonds as liquid assets, even if the bank hasn't set aside capital to guard against their failure.
“That also makes government bonds an indispensable investment for banks,” said Mr. Götz.
Mr. Gallo from the RBS sees things similarly. “Banks must look into where they will lose the least,” he said. Banks are better off taking government bonds with slightly negative yields than they are with parking their money at the ECB with a deposit rate of minus 0.2 percent.
Still, the negative interest is a burden for the banks, emphasized Mr. Götz. “The longer the phase with negative interest holds on, the more it will eat into the margins of the credit institutions,” he said.
Andrea Cünnen covers the bond market from Frankfurt for Handelsblatt. To contact her: [email protected]