This week, yields on 10-year German sovereign bonds, known as bunds, dropped below zero, following a path taken earlier by Japanese and Swiss sovereign bonds and adding to a pile of over $ 10 trillion in sovereign debt and roughly half a trillion dollars in corporate debt yielding a negative return. Yields in 30-year German bonds have followed in lockstep, dropping to a mere 0.55%.
Graph 1: Yields on 10- and 30-year German Bonds
Why, I ask myself, do people invest in securities that yield negative carry? Why not just keep one’s savings in cash or deposited at a bank? In particular, why take so much duration risk for such a low or negative return? Indeed, it is easy to see that at the current juncture small increases in yields would be sufficient to produce huge capital losses. As Bill Gross tweeted last week, “global yields lowest in 500 years of recorded history … This is a supernova that will explode one day” (see also his June Outlook for a more elaborated analysis).
Over time, I have heard answers to this question combining four different arguments:
i. The world has embarked in a period of demographic transition and secular stagnation that will lead to rather low long-term growth. Interest rates have to fall in tandem, to reflect the lower demand for investment.
ii. Although nominal yields are negative, these bonds may yield positive real returns, as low global demand leads to deflation.
iii. Investing on secure sovereign bonds at least guarantees the return of one’s capital, even if this requires sacrificing any return on your savings.
iv. Yields are negative because Central Banks have pushed them that way, in some cases through huge quantitative easing programs. This is the case of the Euro Area, where every month the ECB buys 80 billion euros in European sovereign bonds, € 19 billion of which of bunds.
Although all these arguments make sense to me, I feel they miss one important element: many people invest in these bonds for they expect their yields to fall even further in the future, thus reaping significant capital gains. As shown below, as investors and the ECB flocked into German sovereign bonds, their prices went up. Anyone buying 30-year German bonds six months ago would have gained an annualized return of 47%. Not bad, right? Not bad at all.
Graph 2: Yields and prices of 30-year German bonds
The problem, as I see it, is that this is a huge Ponzi scheme, which only yields significant returns while more money is flowing into these securities. One day someone will be left holding an enormous amount of negative yielding bonds that no one wants to buy. The losses will be huge: according to JP Morgan estimates reported at the Financial Times, if US Treasury yields go up by 1 percentage point, holders of US Treasuries would lose US$ 1 trillion. The same dynamic, if not quite the same magnitude, could be seen if German bund yields were to suddenly rise. More importantly, in a game of “Hot Potato,” who loses when the music stops? The person holding the potato, of course, but the whole regional or even global economy may also get burned.