Making (no) sense of negative bond yields

Negative bond yields may not be exactly top of mind amidst your summer vacation plans and family time. And thank goodness for that! But negative bond yields are a source of preoccupation within the world of finance. They’re making news headlines and since we’ve had a couple of questions about them, we will attempt here to explain the unexplainable.

First, a few facts:

• Globally, $15 trillion of bonds now have a negative yield.
• That equates to over a quarter of the world’s investment-grade bond market (Bloomberg Barclays Global Aggregate Index which includes government, corporate and securitized debt).

What does a negative bond yield mean?

The concept can mess with your mind, but effectively, it means if you buy a bond with a negative yield and you hold it to maturity, your return is guaranteed to be negative. Put another way, you’d be paying someone (a government or corporate issuer) to borrow money from you!

If that makes no sense to you, you’re not alone. In the words of Wall Street bond maven, Joe Rosenberg, it is “just nuts.”

However, there is a rationale (sort of) to the irrationality. Remembering that when yields fall it is because bond prices are rising, if you believe that bond prices will continue to rise, then you may be content to buy a negative-yielding instrument with the intent of not holding it to maturity but rather selling it on a price advance. As Rosenberg said in a Washington Post article, “People are buying into the bond bubble because they’re watching other people making money.”

Why are bond prices rising/yields falling?

Because economic uncertainty is rising. Globally, economic growth is slowing, particularly in the Eurozone, Japan and Asia. Inflation rates are persistently below targets. And central banks around the world are lowering rates to stimulate growth and stem the risk of recession. Tariffs and an escalating trade war between the U.S. and China have repercussions for countries throughout the world. BREXIT – whether a negotiated agreement or a no-deal “hard BREXIT” – will disrupt trade between Britain and Europe. These are to name but a few of the factors hampering growth and causing uncertainty.

Incredibly, negative yields have now spread to EU-denominated junk bonds. That is, bonds considered too risky to qualify as “investment grade.” According to Bloomberg, there are now 14 junk-rated bond issues with negative yields. Surely, this is unsustainable, and things are not “different this time.”

Where to invest in an environment of negative bond yields?

While it is not known when or what will cause the bond bubble to burst, we can be assured that it will. Our Investment Committee is constantly reviewing our asset mix and allocations within each asset class. Every investor should be doing the same.

We have had a reduced allocation to bonds for some time now. As we’ve said repeatedly, we’re prepared to miss some of the upside, as bond yields fall further, in order to stay on dry land when the tide eventually and unexpectedly turns.

We also have maintained a lower-than-typical allocation to public equities – about 40% in a balanced portfolio. With corporate earnings and economic growth slowing, we have difficulty making the case for a larger allocation.

We have a large allocation to cash – approximately 18% in a balanced portfolio. Our Canadian cash balances are earning 1.95%, which, compared to the alternatives is, for the time being, sufficient.

Where we are finding value is in our portfolio of non-correlated private investments, such as multi-family residential real estate as an example. In total, we currently have an interest in more than 30,000 apartment units throughout Canada and the U.S. through a handful of select real estate manager/investors. These investments produce dependable yields from rental income and are not particularly influenced by what is happening in the stock or bond markets.

This year, we will put another $50 million of cash to work in a portfolio of large-scale Canadian apartment buildings located mainly in Toronto and Montreal, cities with very low vacancy rates and high levels of immigration. We will be writing more about our real estate investment approach in an upcoming blog so stay tuned for our thoughts on that topic.

If it’s been awhile since you’ve taken a hard look at the asset mix in your portfolio, now’s the time. If you’d like a second opinion, please feel free to get in touch.