Bond yields are at all-time lows. Today, approximately $13 trillion of global government debt (representing 36% of all outstanding debt) has a negative yield1, compared to almost zero dollars of debt with a negative yield in 2014. That sounds like a big number…but is it important?
Why Should You Care?
Many point to the ultra-low bond yields and seemingly high valuations of U.S. equity markets, and question the potential for portfolio growth using a long-term, strategic approach. While this is uncharted territory for fixed-income markets, it isn’t time to give up on your well-conceived plan. Before delving into why that’s the case, here is a little more background behind what is going on.
What Exactly Is a Negative Bond Yield?
A bond’s yield roughly represents the return that an investor would expect to earn from owning that bond. Today, many government bonds have negative yields — a hypothetical example of this is an investor purchasing a bond for $110, getting $5 of interest over the time he holds the bond and receiving $100 at maturity. Essentially, the investor holding this hypothetical bond paid $110 and received only $105 back — he has a negative return.
Why Would Anyone Invest in That?
For most investors, putting their money under the mattress probably sounds like a better proposition than holding a negative-yielding bond. However, there is always the possibility that yields can become even more negative over time (i.e., the price of the bond goes higher than the original purchase price), so some investors might invest in negative-yielding securities, expecting to sell them prior to maturity.
Additionally, institutional investors, such as banks, may be subject to regulations that require them to hold government securities; therefore, keeping money under the mattress isn’t an option for them.
How Did Yields Become Negative?
It’s hard to pinpoint a single culprit, but slow economic growth and expansionary monetary policies have contributed to where yields are today.
In the aftermath of the global financial crisis of 2008, many central banks engaged in programs of quantitative easing (QE) to stimulate their economies. Essentially, they undertook massive bond-buying programs that were supposed to encourage investment and economic growth; the effectiveness of these policies has been a much-debated matter. Although QE in itself is not the sole driver of negative rates, it certainly has had an impact.
While U.S. Treasury yields are low, they are still positive, whereas government bond yields in Germany and Japan (among others) are now in negative territory. If economic growth rates were higher in Europe and/or Japan, those yields probably would not be negative.
What Does This Mean for Your Portfolio?
With bond yields in the developed economies at all-time lows, many investors are flocking to higher-yielding, complex, illiquid securities. We have not done that in our client portfolios; rather, we have maintained a long-standing allocation to high-yield and emerging-debt mutual funds, which invest in conventional bonds. It is important for investors to exercise caution in their search for incremental yield, as these are the very circumstances in which they can get burned — by overreaching into riskier segments of the market.
So what about those who say, “With yields so low and future economic growth questionable, the potential for future portfolio returns is bleak”? On the fixed-income side, the expectation for lower returns has merit, given where interest rates are; however, on the equity side of things, low returns aren’t a foregone conclusion.
There are a few different arguments put forth by those who expect poor economic growth and lower equity returns:
1. We have been in an expansionary phase for the past seven years, so we are “due” for a recession.
In fact, there are reasons to believe that we are not due for a recession. The current pace of the U.S. recovery has been at a 2.1% annual growth rate versus a historical average of 4.3% for annual growth during recoveries2 — so there is potentially a lot more runway for further economic growth.
2. We are at full employment in the U.S.
On the face of it, unemployment numbers appear to be at lows, but if you peel back the onion a bit further and look at labor participation rates and wage growth, there is still slack in the job market.
3. The equity premium.
One of the ways experts formulate expectations about future stock returns is by adding a few percentage points (known as “the equity premium,” or the additional return that an investor should expect to receive for risking capital in equities) above government bond returns. Using the equity premium, the logic follows that:
Low bond returns = Low equity returns
However, the equity premium can change in different time periods. So, even though the equity premium historically has been at a certain rate, that doesn’t mean it will stay at that rate going forward. Furthermore, with substantial government intervention artificially driving down interest rates, the assumption of free markets that underpins traditional theories of relationships between bond returns and equity returns has been violated. As a result, we cannot presume that low bond returns will translate to low equity returns.
In building long-term, strategic allocations for clients, we recognize that each part of a portfolio plays a distinct role. Core fixed income is the ballast of a portfolio, and global equities fuel long-term portfolio growth. Each of these segments can add to performance in different time periods and market environments, but rarely do they all deliver stellar returns in the same time period. While we are in uncharted territory for bond markets, we should not forget that things can change quickly, and the potential for innovation and animal spirits to propel equity markets to new heights may be right around the corner.