In the era of ultra-loose monetary policy and global imbalances, investors’ hunt for yield has been remorseless - nowhere more so than in the corporate bond market, where yields have come down phenomenally relative to mainstream government bonds. How, then, do we explain Nestlé’s corporate bonds starting to trade last week at marginally negative yields?
Whoever was buying at these levels was certainly not chasing yield. That said, the bonds of the world’s largest food company were simply following on the coat-tails of the Swiss government’s own bonds, which have been in negative-yield territory for some time now. This reflects the tidal wave of global capital that is looking for safe places in a world of high geopolitical uncertainty and worryingly unconventional monetary policy. The yield on Swiss government paper is in turn influenced by negative policy interest rates designed to deter foreign investors from causing the Swiss franc to appreciate, following the central bank’s failed attempt to hold down the currency.
Given the choice between, say, a southern European sovereign bond and the IOU of an exceptionally stable Swiss company with strong cash flow and net debt amounting to just 33.3% of the equity, the case for buying Nestlé bonds yielding less than nothing makes itself. There is every chance that the negative income will be outweighed by a currency gain against a euro weakened by quantitative easing. And the value of Nestlé’s bonds, unlike its shares, will not be much affected by the impact of currency appreciation on its profits and the value of its overseas assets.
Negative yields, I suspect, are here to stay and we will see more countries and companies showing them in due course. In the sovereign debt market, already the short-term paper of France, Germany, the Netherlands, Denmark, Finland and Sweden, as well as Switzerland, yield minus quantities. In a low-growth world, some countries are seeking to increase their share of the global economic cake through competitive devaluation; others are pursuing ultra-loose monetary policies for primarily domestic reasons that happen to result in a weaker currency. Countries that take the strain via currency appreciation will increasingly be tempted to inflict negative interest rates on capital inflows. The US is the notable exception. Traditionally it chooses not to fight market forces when the dollar strengthens.
In the eurozone, negative yields reflect the reality of deficient demand and the fear of deflation. The impact on yields is likely to be exacerbated by a shortage of prime government paper as the European Central Bank embarks on its proposed bond-buying venture. Yet that leads to another paradox. If investors are increasingly worried about deflation, why are so many index-linked bonds around the world offering negative real yields? This seems counter-intuitive when the enormous expansion of central bank balance sheets in the US, UK, Japan and the eurozone has signally failed to reignite inflation.
One reason, as I have discussed here before, is that institutions with index-linked liabilities would be so badly hit by a return to high levels of inflation that they feel obliged to take out the insurance, almost regardless of cost. Another is that some investors believe that inflation is a real threat and that the deflation scare will cause people to be too relaxed about an inflationary take-off.
As we watch Japan struggling to raise the price level through one of the biggest liquidity injections in history, this fear may seem exaggerated. Yet it is not stupid. Since the financial crisis, global debt levels have risen considerably, especially in the public sector. Servicing the debt, relatively easy today unless you are Greece, will become much harder when interest rates start moving towards levels closer to historical normality.
It is conceivable that investors, nursing losses on bond portfolios whose value has been savaged by rising interest rates, will lose their appetite for the paper of over-indebted governments. If the central banks are then forced to finance government deficits directly, the switch from deflation to inflation could happen very fast.
Japan will be an early test case.
Copyright The Financial Times Limited 2015