SUB-ZERO BONDS WILL CHANGE RISK CALCULATION / THE FINANCIAL TIMES MARKETS INSIGHT

Markets Insight

February 18, 2015 4:58 am

 

Sub-zero bonds will change risk calculation

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Search for yield will evolve into a flight from near-certain loss

 

©Bloomberg

 

 

The hunt for yield is entering new territory. The European Central Bank’s landmark decision to unleash quantitative easing marks the beginning of a precarious phase in this erratic financial cycle.

 

Precarious because the move appears to eliminate the distinction between what is risky and what is safe.

 

Government bonds may have been tolerable investments when their yields were near zero, but they are unlikely to be so now. Buying sovereign debt today often means locking in a loss at redemption.

 

That is not to say yields cannot dip further into negative territory. The ECB, some tightly-regulated financial institutions and banks could continue to buy government debt whatever the price. And should deflation prove a more stubborn foe than central banks envisage, sovereign bond yields could indeed fall further.

 

But the predicament facing investors in need of some capital protection is the toughest in living memory.

Thanks to central banks’ increasingly aggressive financial repression — the deliberate driving down of interest rates to levels below inflation — negative bond yields have never been so widespread.

After the ECB went public with its QE plan, nominal bond yields turned negative across vast swaths of the sovereign debt market.

At one point, about 16 per cent of the bonds in JPMorgan’s government bond index, some $3.6tn, and one in four eurozone sovereign bonds were offering negative yields.

Meanwhile, investors wishing to lend money to the Swiss government over a period up to 10 years have found themselves having to pay for the privilege. The trend has also spread to the corporate debt market, where yields on consumer food group Nestle’s four-year euro bonds briefly fell below zero.

It is doubtful that investors can put up with this for much longer. To avoid an almost certain loss, it is possible they will end up taking on more risk.

There is a large body of evidence testifying to investors’ powerful aversion to loss. This was demonstrated more than 30 years ago by the behavioural economist and Nobel laureate Daniel Kahneman, who found individuals were prepared to take on more risk than normal if the alternative — doing nothing — meant accepting a loss. Tellingly, the pain of a $100 loss was found to be far more intense than the satisfaction from a $100 gain.

In other words, when the probability of suffering a loss is high, individuals’ natural aversion to risk gives way to a powerful risk-seeking impulse. This is the central tenet of Prospect Theory.

From this vantage point, it is easy to see how investors might respond to central banks’ latest dose of financial repression. Asset classes once considered risky could plausibly acquire haven-like qualities,

 

There are certainly plenty of candidates vying for the title of new haven. This is another distinguishing feature of this financial cycle: unlike the deflationary periods of the past, investors are spoilt for choice when it comes to fixed income investment options.

Emerging market sovereign bonds are contenders — developing economies remain less indebted than their developed counterparts, possess favourable demographics and are probably better governed than they have ever been.

Corporate bond markets, meanwhile, are evolving into a rich hunting ground, particularly in Europe, where bonds are replacing loans as the funding vehicle of choice for a wide array of companies. And so far, default rates have remained well below the historical norm.

Dividend-paying equities — or quality stocks with bond-like characteristics — clearly lie at the riskier end of the spectrum but, as investment flow patterns show, they are favoured for their defensive attributes. Since 2011, net inflows into global equity income funds have averaged €4.2bn per year.

So the blanket search for yield will evolve into a flight from near-certain loss. That is sure to underpin the prospects for credit securities and defensive stocks over the medium term.

Longer term, the picture might not be quite so healthy. Taking on additional credit will require investors to be more discriminating. The credit standing of high yield companies, for instance, is hardly set in stone.

What is more, as central banks continue to experiment, inflation expectations will probably become more volatile over the long run. Bonds may prove the asset of choice if inflation remains low, but they will not offer capital preservation should it accelerate. Shrewd tactical asset allocation will be a must.


Percival Stanion is head of multi assets at Pictet Asset Management