Negative yielding European junk bonds: High risk, low reward?
Central banks are becoming even more accommodative across the world, putting downward pressure on fixed income yields. This is true even in riskier assets and has important implications for positioning in investors’ fixed income sleeves.
Fixed income yields are falling – even in riskier assets
Lower benchmark policy rates have become standard since the Global Financial Crisis, punctuated at times by large-scale asset purchases or quantitative easing (QE). Even in the U.S., where we have seen a gradual tapering of support and increase in interest rates, the Federal Reserve may be changing course. Other central banks are following suit, potentially pushing already low bond yields even lower.
Lower interest rates have helped to support economic recoveries – albeit slow ones – in many countries. However, these policies have had side effects that impact financial assets.
One of these side effects is that some bonds are now earning negative nominal yields. In fact, nearly $10 trillion of government and corporate debt instruments have negative interest rates. In other words, investors in these bonds do not recoup any earnings for their investments.
In recent weeks, this theme has expanded into even riskier financial instruments: European junk bonds. The headline was, for the most part, a hyperbole – negative-yielding junk debt is a technical point – but the truth may equally shock you.
In some cases, we do not see risky investments being rewarded appropriately
High yield bonds in Europe are getting the “negative yield” attention because 14 companies (about 2% of the index) offer negative yields. The point is technical; these bonds are short-dated high yield bonds that are either due within 5 weeks, or “in the money” and thus callable immediately. When the market has high conviction that they will be paid or called immediately, it is possible that the price falls so low you end up with negative yield.
Still, the ugly truth is that many high yield bonds in Europe trade offer between 0% and 1% return.
How does the U.S. look in comparison? At first glance, the difference is stark: the Bloomberg Barclays Pan-European High Yield Index yields about 3.5% compared to the US high yield benchmark of closer to 6%. However, after adjusting these valuations for the risk, the index yields are much more comparable (option adjusted spread 350 and 370 bps respectively, below). The difference is made up by their respective government yields; the 10-year German bund yields about -30 bps versus the 10year US treasury at +200 bps.
Junk bond yields are low, but not yet negative
Source: New York Life Investments Multi-Asset Solutions, Bloomberg Finance L.P., as of 7/23/19. Option-adjusted spread (OAS) is the yield spread added to a benchmark yield curve to account for its embedded options.
Why, then, are investors still purchasing these bonds with low yields and tight spreads? For many investors it’s not about absolute return but relative return – even if yields are low, junk bond yields are higher than those of safer assets. At the same time, even the truly negative-yielding government bonds can be more liquid and easier to trade than cash settlement. There are costs – hedging and trading costs can be restrictive, and many institutions are constrained by mandates – but overall demand puts a lid on yields.
How should investors treat these assets in their portfolios?
Fixed income pricing could evolve in two ways from here: (1) credit prices could catch up with their fundamentals – slowing global growth, headline risk, high amounts of corporate leverage – resulting in wider spreads. We got a taste of this option in Q4 2018. Or (2) credit prices continue to track monetary policy – Fed on hold or potentially cutting rates, ECB signaling further cuts, Japan buying assets, China managing its slowdown, emerging market countries easing conditions – resulting in maintained tight spreads.
We are encouraging investors to reduce risk in their fixed income portfolio. Valuations are elevated, increasing the risk of loss. In our Multi-Asset Solutions portfolios we have increased our overall credit quality by increasing our investment grade duration while keeping our credit duration short and diversified.
This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.
The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.
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The Bloomberg Barclays Pan-European High Yield Index measures the market of non-investment grade, fixed-rate corporate bonds denominated in the following currencies: euro, pounds sterling, Danish krone, Norwegian krone, Swedish krona, and Swiss franc. Inclusion is based on the currency of issue, and not the domicile of the issuer.
“New York Life Investments” is both a service mark, and the common trade name, of the investment advisors affiliated with New York Life Insurance Company.