A central bank that’s desperately trying to ignite a borrowing/spending frenzy to offset an incipient recession has one wish above all: That the currency it’s creating flows beyond safe-haven assets and into riskier niches. Call it the democratization of credit or Ponzi finance. Either way, the result is a lot of borrowing and spending, which solves the immediate slow-growth problem.
So it must come as a pleasant surprise for monetary authorities that a growing number of “high-yield” bonds are trading with negative yields. You read that right: some junk bonds now yield less than nothing.
So far, this is happening mainly happening in Europe, where the ECB has been soaking up the bonds of junk countries like Italy, producing Italian government bond yields comparable to those of the US and not far from Germany’s. Now some of this torrent of newly-created euros is flowing into the corporate equivalent of Italy, sending the share of one-step-above-junk BBB rated bonds with negative yields to double-digits. Meanwhile, the share of actual junk bonds with negative yields is above zero and rising fast.
For the entire universe of European BB-rated bonds (to repeat, these are junk), the average yield is now comparable to what the US pays on 10-year Treasury bonds.
So why is this happening, and is it as bad as it seems?
The short version of “why” is that when a country borrows too much money, its rising debt slows future growth unacceptably, leading politicians to bully central banks into cutting interest rates further and buying up more assets. Eventually, this process reaches its logical conclusion, which is zero-to-negative interest rates and central bank balance sheets stuffed with assets of laughably low quality. Which is where Europe now finds itself.
And still, the politicians demand more. So rates go negative across the high-quality yield curve (German 10-year paper now yields -.30%), forcing everyone who needs income to move into junkier assets. And voila, high-yield starts trading like Treasuries.
As for why that’s bad, well, let’s count the ways. First, it funnels cheap capital into companies that by definition don’t deserve it, which results in “malinvestment” on a vast scale. Second, it starves pension funds and retirees that need income, forcing them to take on ever-higher degrees of risk. Combine massive misallocation of capital with excessive risk-taking by investors who don’t understand risk, and the result is an epic crash when junk borrower cash flows inevitably disappoint.
Why do investors put up with it? Saturday’s Wall Street Journal offers a chilling explanation:
One euro junk bond from U.S. packaging company Ball Corp, for example, trades at a yield of minus 0.2% and matures in December 2020. That compares to a European deposit rate of minus 0.4% or a yield on a German government bond with a similar maturity of about minus 0.7%.
The choice for investors is about the balance between needing to stay invested and how much risk to take, according to Tim Winstone, a fixed-income portfolio manager at Janus Henderson. A bond like Ball Corp’s is “a safe place to hang out,” Mr. Winstone said. “And just because something is negative-yielding, that doesn’t mean it can’t get more negative-yielding.” Falling yields mean rising bond prices and gains for investors, at least on paper.
Many expect more bond yields to go negative as central banks in the U.S. and Europe cut interest rates or return to bond-buying to stimulate economies. In Europe especially, investors are realizing that negative interest rates are going to last a long time because the ECB needs to overshoot its inflation target to make up for the long spell when inflation has been far below 2%. Without a period of higher inflation, it won’t meet its target on average over the medium term.
The number of junk-rated companies with negative-yielding bonds will definitely go up, according to Barnaby Martin, credit strategist at Bank of America Merrill Lynch. “It doesn’t take much for it to go from 14 companies to 30 or 50 or 100,” he said.
In other words, investors are now extrapolating falling interest rates into the future and playing junk bonds for the capital gains they’ll generate when their future borrowing costs go down. This is one of those sentiment shifts that financial historians will single out for special attention when sifting through the rubble of the coming crash.