BONDS HIT BOILING POINT THANKS TO ECB / THE WALL STREET JOURNAL

Heard on the Street

Bonds Hit Boiling Point Thanks to ECB

European bond markets are looking increasingly stretched as capital gains gain focus at the cost of income

By Richard Barley

March 16, 2015 7:43 a.m. ET
   

The European Central Bank’s new building in Frankfurt, Germany, which opens its doors this week. The start of the ECB’s bond purchases last week had a surprisingly big effect. Photo: European Pressphoto Agency  

For a policy so long and so public in the making, the start of government-bond purchases by the European Central Bank last week had a surprisingly big effect. Already superlow sovereign-debt yields fell even further—the 10-year German yield dipped at one point under 0.2%. But bond markets are looking increasingly stretched.

In the near-term, ultra-low yields can persist in Europe. The presence of a big, price-insensitive buyer, the ECB, will have a powerful impact. Continued tensions between Greece and the eurozone are likely to support bond prices, too; a flare-up that raises the risk of a Greek exit could push German yields lower still.

Japan’s experience also shows yields can stay low for longer. Meanwhile, bonds have demonstrated an unexpected capacity to produce outsize capital gains as yields have turned negative for vast swathes of the market.

Still, it is hard to escape the idea this process has its limits—and may be approaching them.

Even during the many years of quantitative easing in the U.S. yields for all but the shortest-maturity debt never turned negative. On a long-term investing horizon, today’s European yields look decidedly bubbly.

          

If nothing else, low and negative yields, are challenging a fundamental reason for buying bonds: steady income. Instead, buyers increasingly appear to be betting on capital gains. That is effectively turning debt managers into stock investors; “fixed income” increasingly looks like a misnomer. That is a worrying development, especially given most investors have become so used to the decades-long bond bull market.

 

Fixed-income prices in Europe show this more vividly than yields. Bond prices have reached stratospheric levels. Take the German 6.25% bond due 2024. It was originally sold as a 30-year bond at the end of 1993—and the coupon serves as a reminder of the kind of return investors expected back then. The bond was issued at just above face value. Today, an investor buying €1,000 face value of that bond would pay €1,549, including accrued interest, according to Tradeweb.

Over the bond’s remaining lifetime, investors will receive €562.5 ($590.2) in interest and €1,000 at maturity, for a total of €1,562.5. So, the price is 99.1% of total future cashflows an investor has the right to receive. In other words, the bond will produce virtually no income over its lifespan.

Sure, the bond’s price could yet rise further. Unless yields go massively negative, though, gains won’t be that large. Meanwhile, downside risks are big: a one-percentage-point rise in yields—taking them to where they were in June—would push the price down around 7%. And if Europe’s economy gains traction, investors may find they really have been trying to gather pennies, and in some cases not even that, in front of the proverbial bulldozer.

It’s not just German bonds that are behaving unusually. Austria’s government bond due in 2062—originally issued as a 50-year bond—is trading at 210% of face value and yields just 0.9%. Corporate bonds aren’t far behind. French energy company GDF Suez early in March issued €2.5 billion of debt that included a €500 million two-year zero-coupon slice—essentially borrowing for free.

ECB purchases may even have exacerbated this problem. Understandably, much focus is on technical factors such as flows, liquidity and issuance: how much will the ECB buy of what bond at what price? These factors are undeniably powerful. But they are essentially divorced from economic fundamentals.

Until recently, those fundamentals were more supportive of low yields: inflation was plummeting and eurozone growth was a fabled hope. But the growth outlook has improved; inflation expectations are still low but have started rising. Indeed, the point of the ECB’s bond buying is to revive the European economy. That should ultimately prove bad news for bonds.

At some point, albeit perhaps not quickly, fundamental factors should reassert themselves.

When that happens, the realization that bonds have had their innate investment characteristics crushed and that capital gains are a thing of the past will result in a rude awakening for many investors.