US bond yields are low and projected to move lower, but nowhere near as low as German bond yields, which are actually below zero. That’s right – negative.
Does that mean German banks are paying interest to homeowners with mortgages rather than the other way around? Are German car buyers getting paid to borrow money to buy cars? Not exactly. German bond investors are actually earning interest on bonds they own. However, bond prices have been bid so high, that the interest earned over the life of some bonds is less than the added premium paid for the bonds. For example, the price of a 10-year German bond that will mature at €100 (par value) was recently quoted at €104. But the interest rate on the same bond was just 0.25%. Typically, a bond’s interest rate will compensate an investor for paying more than its par value. But here the interest amounts to just €2.50 over 10 years. With an initial outlay of €104 (-), interest of €2.50 (+), and a return of €100 (+) at maturity, an investor loses €1.50 on every bond. That guaranteed loss is why the bond is considered to have a negative yield. Prices on German bonds could theoretically move higher over the next 12 months and we could see yields even more negative, giving today’s buyer a profit. Still, bonds held to maturity will result in a loss.
More confounding than the concept of negative bond yields is the idea that a rational investor would buy a security that’s more-or-less guaranteed to lose. It goes against the very fundamentals of investing. An Investor doesn’t pay a bank to have a savings account or buy stocks that are expected to lose value, but that’s essentially what’s happening here. Globally, other options are readily available.
But while US bonds yielding 2% might appear infinitely more attractive than a German bond yielding -0.3%, currency risk and regulatory restrictions can dim their appeal for German investors. A German investor with €100 can convert that into $112 and buy a 10-year Treasury yielding 2%. After 10 years, the German investor would have $134. However, that $134 could end up buying more or less euros depending on currency movements. After all, ten years is a long time. Further, hedging those currency moves can be costly enough to wipe out the additional yield provided by the Treasury bond. In fact, Bloomberg recently detailed how hedging costs make positive-yielding Treasuries less attractive than negative-yielding German bonds. Further, institutional buyers like pension funds typically seek out (or may be required to seek out) safe local options – government bonds.
On the U.S. front, JP Morgan recently predicted that the 10-year Treasury yield will sink to 1.75% by the end of 2019, not far off the low of 1.4% from 2016. Lower rates could be a result of a weakening economy, further stock market volatility, and/or growing trade conflicts. U.S. bond investors may scoff at earning such a seemingly paltry yield, but they simply need to look to their German counterparts earning less than nothing to sleep a little easier.
For more information on this topic, please contact Scott Berry.