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Forest

What to do about negative yields?

Negative yield nominal bonds have received a lot of press, with trillions of dollars of these bonds outstanding. Why has this happened, what does it mean, and how should investors react?

Global negative yielding IG debt

Source: Deutsche Bank

Most commentators point to quantitative easing as the cause of negative bond yields. Whilst this is true, it is not the root cause. We think the main culprit is in fact a global economy with low demand, and therefore excess supply capacity, that persists despite low rate and quantitative easing policies enacted to remedy these problems. Demand to use low rates to fund productive investment cheaply is lacklustre, because demand for resulting products or services would be too low. Firms won’t invest in this type of environment – instead, they will utilise part-time labour (or no labour) to allow productive capacity to adjust according to underlying demand. Many workers are therefore underutilised (a problem the RBA is currently grappling with).

Change to this backdrop will require expansionary fiscal policy that governments globally show little sign of embracing. So negative yields will persist and there will be investors who will lend a borrower $102 (say), receive no interest for a period of 10 years or longer, and receive only $100 back at maturity. Why would investors do this? Some are forced to by regulation. Others are willing to pay for ‘safe’ government debt regardless. Others still are buying solely because they believe yields can move even further negative.

What are long-term investors to do against this backdrop that slowly erodes wealth? Three points should be considered:

Active management

Active investment management is key. Many fixed income benchmarks are heavily weighted to negative-yielding bonds and have become more sensitive to the impact of short-term backups in bond yields. Active managers can choose to avoid this volatility very easily, particularly because negative yields are concentrated in only a few jurisdictions (e.g. European countries and Japan) at this stage.

Diversification

Fixed income capital markets are more than $100 trillion in size. So, there are plenty of investments to choose from without needing to take on particularly low yields or undue risk. For example, highly-rated corporate debt offers a safe alternative to government bonds – many well-known Australian and global companies raise funds in the bond market, instead of or in addition to using banks or issuing shares. A diversified and very high-quality portfolio can be built providing a good income stream while remaining defensive.

Risk mitigation

Fixed income investments should not have too much exposure to one risk factor. For example, many bond funds are over-exposed to interest rate risk, which seems questionable with interest rates already so low. Portfolios generating returns from a range of sources are preferable for investors seeking sustainable income.

It is still possible to find portfolios offering sustainable income without taking undue risk. Investors need to look for actively managed products generating returns in a range of different ways to successfully navigate this lower for longer world.

Disclaimer: Please note that these are the views of the writer and not necessarily the views of Daintree Capital. This article does not take into account your investment objectives, particular needs or financial situation.