Sunday, August 25, 2019

The upside down, inside out negative yield financial world

As Keynes has said “The market can stay irrational longer than you can stay solvent.”

Fixed income investors are having a great laugh with strong bond performance this year as yields move further into negative territory in many countries and close to all time lows in the US. The individual facts are astounding. The German government issued 30-year bonds with negative rates. The Austrian 100 year bond is at a zero rate. 44% of the Barclays/Bloomberg Aggregate index outside the US is negative. The dollar amount of negative yielding bonds is now $15 trillion. The Eurozone investment grade bond index has a yield to maturity of .24 bps. Every basis point decline in yield places more debt into negative rate territory. You can now borrow for a negative rate mortgage in Denmark.

Try explaining negative rates to anyone and you are immediately placed in an odd world. There is no normal time value of money. Yes, there is time value except a lender will give you the use of their money today in exchange for less money tomorrow. A borrower can obtain money today with the promise to give the lender less money tomorrow. The lender says that he has no known use for his money and would rather give it to someone else in exchange for less money in the future. 

The credit is willing to take a penalty for giving up the use of their capital as debt. They must be very afraid of future returns for equity. While there are other alternatives, creditors are willing to lock-in a sure loss over the uncertainty of something else. Note that holding paper money will lock-in a loss of zero. The risk of inflation applies to bonds and cash. Insurance companies with long liabilities are saying that they will take a penalty to closely match their long-term obligations and there is little fear of any future inflation. Creditors are driving up bond prices to create negative yields, a form of scarcity. 

What is as surprising as creditors accepting these negative rates is the lack of new government bond issuance at these rates. For all the countries that have negative rates, it seems that they should be exploding their balance sheets for any capital improvement project that has a positive net present value. This should continue until rates are driven higher. 

You can spin this story a number of ways and still generate an absurdity. If normal creditors and lenders cannot provide a reasonable story for their negative time value of money, we are left with an explanation that these negative rates are imposed on the markets as a form of financial repression by central banks. 

This cannot continue. This is an easy comment to make, but one that does not help the investor who has to take action today. "The markets can stay irrational..." Still, investors should be looking for any uncorrelated alternative to this bond bubble.

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