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Getting Paid to Borrow?

Published by: Nathan Smith Date: October 18, 2019

Getting Paid to Borrow?

Sometimes the truth really is stranger than fiction. At a German Bund (actual name) auction in August, investors were willing to “pay” for the privilege of owning their 30-year bonds. The bond auction resulted in a rate of -.11%. While this took many investors by surprise, it has become more commonplace in Europe, Japan, and other parts of the globe to have bonds that are yielding below zero. There is now more than $17 Trillion worth of government debt that is sporting a negative yield. The graphic below from Bloomberg illustrates the mechanics of a bond with a negative yield.

Source: Bloomberg

It seems counterintuitive that any sane investor would be willing to purchase something that guarantees them a loss if held until maturity. But with $17 Trillion in negative-yielding government bonds worldwide clearly, there is demand in the global capital markets for these types of bonds.

So who are these investors, and what are the motivations for owning this debt?

The following are some of the entities that would own negative-yielding government bonds:

* Central Banks- The European Central Bank (ECB) and Bank of Japan (BOJ) are actively buying these bonds. The policy is aimed at enticing its citizens to invest in higher-risk assets like stocks and real estate to boost their sluggish economies.

* Pension Funds- These types of funds have specific mandates on the amount and type of bonds they can own to meet future disbursement obligations. So these funds are handcuffed and must purchase these bonds.

* Index Funds- Since these bonds are components in bond indices worldwide, any investor that owns a bond index fund by default will own these bonds.

* Traders- Many traders own these bonds in hopes of selling them in the short-term as yields continue to move down, and prices go higher, or at least that is what they think.

* Individuals- Small investors may have long-term financial goals that involve owning a certain percentage of bonds in their portfolios. While negative yields aren’t something that will help to accumulate wealth through interest payments, it is undoubtedly less risky than the alternative of owning stocks.

If you look at the last 30-years of the returns in international stocks and bonds, a pretty striking fact emerges between what happens in the best years of returns versus what has happened in the worst years from 1990 through 2019.

Source: DFA Returns Program

As you can glean from the information above, the best versus worst years for stocks and bonds are drastically different. The worst one year period for stocks was down 50.2%, while the worst year for bonds was only down a 3.6%. In relative terms, this means that stocks investors in the worst years are exposed to 14 times the amount of losses as bond investors in their worst year.

Conservative investors that don’t have the luxury of a longer time horizon can’t afford to take the risk of increasing their allocation to stocks over negative-yielding bonds. Knowing that a bond will guarantee a manageable loss is much better than looking at a stock market that could decline significantly over a one, three, or five year period.

The good news is that the majority of bonds still offer investors positive yields, and for U.S. investors, they can own negative-yielding bonds and attain positive expected returns through currency hedging. Investors should refrain from responding to attention-grabbing headlines and maintain focus on managing risk and long-term portfolio allocations that will help achieve and maintain financial freedom.