Behind the logic of buying bonds on negative nominal yields

7 September 2016

Once you have battled through his inane introductions, Bill Gross (alias ‘The Bond King’) invariably has something interesting to say and his September Investment Outlook is no exception. This monthly sounding board has followed Bill Gross from PIMCO to Janus but the introductions are as baffling and irrelevant to the following content as ever.  The reward for reading some convoluted personal story about his shower, or dog, or high school basketball team is often a profound investment insight.
This month, once you have traversed the paragraph about golf balls, there is the observation that “US$11 trillion of negative yielding bonds are not assets – they are liabilities”. Not only is this a memorable one-liner, it provides ample food for thought.
On the basis that “an asset is a resource with economic value that an individual, corporation or country owns or controls with the expectation that it will provide future benefit”, then Gross is correct. Holding a bond bought on a negative nominal yield to redemption will crystalize a financial loss, not a profit: the value of the coupon payments will be outweighed by the capital loss on redemption.
Supposing that the purchasers of underwater bonds have their marbles intact, what are their possible motivations? I can think of four. First, the investor is acting under regulatory coercion: he or she is obliged to hold a fixed income ‘asset’ that matches the length and type of their liability, or that fulfils the provisions of Solvency 2 or has a zero risk-weighting for Basel 3.
Second, there is corporate treasurer or family office custodian that cares not for the yield but places paramount value on the option value of high quality liquidity. In other words, the utility of a short-dated government bond exceeds the carrying cost. Better to lose a small, but known, sum of money than to risk losing an unknown, and potentially larger amount.
Third, there is the speculator who hopes that the yield will fall further into negative territory and thus the bond price will rise in defiance of its destined plunge to par value. A variant of the speculator is the foreign investor who is willing to hold negative yielding bonds if she thinks that the base currency is materially undervalued: the prospective exchange gain will exceed the nominal capital loss in the currency of issue.
Finally, there is the deflationist. Deflationists live in an upside-down world in which it makes sense to give up current capital in favour of a lesser amount of future capital because money in the future will be worth more than today’s money. So much more valuable will tomorrow’s money be in relation to today’s money that even a negative nominal yield serves as no deterrent.
So, there you have it. Central bankers and academics may pontificate about the attractions of increasing the inflation target, but the prevalence of negative nominal yields is designed to appeal to deflationists who reckon that there is no chance of inflation returning even to the muted annual rate of 2%. They invest in government bonds to express their belief in the failure of policy, not its success.
How long can the markets, or capitalism in general, continue to function with the distortions that negative interest rates bring?

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