Negative-yielding bonds. What an absurd construct. Thank God they have all but disappeared as the rate-tightening cycle has hit its stride. But the normalization of the rate structure along with wider credit spreads raises questions about asset allocation in 2023.
The very idea that an investor has to pay to lend money to a borrower seeking funds to back a presumably profit-seeking venture reverses the rightful balance between the two parties and subverts the concepts of time value of money and credit risk.
Until recently and for more than a decade, perhaps the key datapoint demonstrating the colossal asset price inflation central banks created with their zero and negative interest rate policies and gigantic asset purchase programmes had been the spectacular (and to some people alarming) rise in the sheer volume of bonds carrying negative yields.
The number became shorthand for how central banks had destroyed the relationship between risk and return in the name of keeping credit flowing to the real economy. The number topped out in 2020 at almost US$18.5 trillion, according to a piece I saw recently in the Wall Street Journal.
The fact that bond investors were able to generate positive returns on their negative-yielding bonds as yields went ever lower (and bond prices went up to compensate) was a real head-scratcher. Not in terms of the bond maths but in terms of how and where it was all going to end. I mean, having a negative-yielding bond portfolio outperform because benchmark yields have gone even more negative hardly seems a credible investment strategy.
Well, the volume of bonds carrying negative yields has fallen 99% since that peak number to around US$250 billion, again according to that WSJ story (which used Bloomberg data accessed via FactSet).
The effect on global bond returns as the market has quickly normalized on the back of interest rate rises has been ugly. However once the dust settles – and assuming it is allowed to settle without any new calamitous headwinds – bond investors will finally be able to look at the market through a more traditional value lens.
After all, it wasn’t just government bonds from the world’s leading economies whose yields turned negative. Investment-grade corporate debt was dragged along with them, as was some emerging market debt and some segments of the high-yield bond market. Capital allocation strategies were transformed as investors desperately sought to eke out reasonable returns on their investments.
If benchmark bond yields stay at their current levels or go higher and credit spreads widen even more on the back of a deteriorating macroeconomic picture, you have to wonder how the capital allocation narrative will play out in the coming year.
In recent years, investors who had traditionally plied their trade in the safe, boring, low-risk, close-to-home areas of the bond market were forced to become ‘yield tourists’ in their hunt for returns. That meant venturing – tentatively to start with but headlong before too long – into higher-risk neighbourhoods.
They went down the credit spectrum from investment grade into sub-investment grade and into emerging and frontier markets. They went along the maturity spectrum into long and ultra-long-dated debt. They went down the capital structure from secured and senior unsecured to subordinated, mezzanine and hybrid debt. They ventured into structured products and into alternatives; or engaged in derivatives-driven strategies targeting high-yielding foreign currencies.
Everywhere central bank asset purchase programmes went yields went with them, as lenders of last resort became buyers of first resort in both primary and secondary bond markets. With bond returns where they are now, the need for investors to shop in unfamiliar territory receded. That means some market segments that were generously funded in recent years will struggle to attract the same volume of capital as the broad market reverts to form.
That will bring with it certain consequences. I’m not necessarily suggesting a swathe of corporate Europe will be denied access to capital. Away from the bond market, competition between relationship banking groups in Europe will ensure that bankable small and medium-sized enterprises will continue to have access to funding and liquidity lines. Guidance from banks doesn’t infer a dramatic pullback in credit extension or a dramatic tightening of underwriting criteria, while loan loss forecasts currently look manageable.
But the change in market conditions means capital costs at anything remotely like the levels borrowers had become accustomed to have long gone. Corporate lenders tell me some borrowers are unhappy about the rapid change in financing conditions. But borrowers have had it their own way over a long cycle and any attempt to hold out for a return to former conditions will be futile.
The market has been volatile of late and levels are likely to have swung above and below reasonable fair value. What defines fair value will become apparent as issuers get to work on their 2023 borrowing requirements. But the coming year will be a year of transition as the market adjusts, Back to the Future-style.