Do negative yields really matter?

I always judge the severity of any market theme by how often it crops up in conversation around the desk. And in truth, we don’t talk about negative yields at all.

I can see why people might think that negative yields are important. Just a month or two ago, the value of the negative-yielding bonds in circulation was around $17 trillion. As yields have risen recently, that’s fallen back to $14.5 billion. But it’s not just government bonds: we are also seeing corporate bonds with negative yields. These are typically issued at a premium to par and redeemed at par.

This causes structural problems in the pensions industry – and that colours our asset-allocation choices. Sectors such as insurance are affected, because it is harder for them to meet their long-term liabilities. So asset allocation becomes a judgement on who has more closely matched their liabilities and who has a growing liability gap.

Although most insurance groups will tend to keep bonds from the time bought to the time they redeem, negative-yielding debt still poses them problems. Insurers’ future profitability, at least in part, depends on excess returns over their expected liabilities; to get more return, insurers take more risk. Tighter regulation over the last 10 years means that more capital is being kept against higher-risk positions. At some point, the balance moves against the firm’s profitability, and they stop taking more risk. Typically, this prompts insurers to hold government debt and high-grade corporate debt – the very areas where negative yields are most prevalent. This gradually erodes future profitability, reducing a natural capital-building source for these companies. And this, of course, affects leverage and credit quality as well.

And for the banking industry, negative yields matter because the yield curves flatten out and invert. For banks borrowing at a deposit rate of, say, -0.5% but lending longer, it’s hard to make money. So profitability in the banking sector is hard to come by when the yield curve is flat or inverted.

Yields are not a good indicator of total returns

So negative yields can be important for asset-allocation choices. But apart from these instances, negative yields don’t really impinge much on our investment decisions. We have seen little evidence that the yield gives you any clear indication of what returns you are likely to achieve over the next 12 or 24 months.

If you had bought bonds 30 years ago, at the start of this amazing downshift in yields, you might have anticipated returns of around 15% at one point in 1994. But you would not have got anything like that return. You would have got much more. And you would not have bought Austrian 100-year bonds last year at par and ever have expected them to hit 170 or 180 in one year. These returns have blown those from equity markets out of the water.

Yield is one of the worst predictors of total return over the medium or short term. It’s a big red herring for running a fund on a day-to-day basis.

So what can you conclude? Yield is one of the worst predictors of total return over the medium or short term. It’s a big red herring for running a fund on a day-to-day basis. We look to find assets that are going to outperform the benchmark or are outright good things to buy – assets whose credit quality is mispriced and which are going to give investors good returns.

Funding differentials

That doesn’t mean that we shouldn’t buy a euro-denominated negative-yielding bond. By the time we’ve switched it back into sterling, we can add another 130 basis points a year. That’s because of the way the foreign-exchange (FX) market works. If I buy 100 euros today, I convert my sterling to euros straight away to pay for that. At the same time, I will hedge the currency risk in three months’ time, or do a forward FX transaction to sell euros back into sterling. That means I can lock in that forward three-month FX today. Because of the current funding differential between sterling and euros, I can add an annualised 130 basis points to every position I buy in Europe. So I could buy a bond with a yield of -0.5% and still achieve a 0.8% yield in sterling.

End-of-cycle investments

So if negative yields don’t loom large in our thinking, what does? Far more important to us is our belief that we are close to the end of the economic cycle. Manufacturing purchasing managers’ indices (PMIs) around Europe have been awful lately, and Germany is in a recession right now (in my opinion). Germany’s manufacturing PMIs were expected to come in at 44 but came in at 41 (any reading below 50 indicates contraction). That number takes us back to the levels of the global financial crisis more than a decade ago.

So Germany is in a recession, and European growth is going to get pulled down. Think of it like a stone skimming across the water. We will pop in and out of recession a lot in Europe and Germany over the next few years. And despite all its efforts, the European Central Bank is running out of ammunition to deal with the situation.

This is a tough environment for growth. So, rather than just relying on global or European growth, companies need to think about other ways of generating revenue and growing their market. And that’s where we find many things that are much more interesting than negative yields.

Upping the quality

In this environment, we look for companies that will improve the quality of our portfolios through the quality of their businesses. Companies can improve the quality of their businesses in various ways. And by spotting and investing in these businesses, we can improve the quality of our funds.

But in a slowing global economy, that is becoming more difficult. It’s not only about buying single-A bonds rather than BBBs. This is not just about credit quality, but about environmental, social and governance (ESG) factors. We try to find companies that are acknowledging the sea-change in consumer behaviour here.

One good example is Digital Realty. A cloud storage business, it’s hardly a household name. Digital Realty is a San Francisco-based company with a market capitalisation of more than $25 billion. It is described in its Wikipedia entry as “a real estate investment trust that invests in carrier-neutral data centres and provides colocation and peering services”.

None the wiser? In fact, its business is fairly straightforward – it’s just space for computers. Think of it as a big shed for fridges. Servers run really hot, so most of what Digital Realty is doing is providing security, broadband access, cooling and storage.

The cooling takes up an awful lot of energy. Digital Realty’s revenue growth is stalling a bit at the moment, and competition is intensifying. So the company is trying new things – it is ‘greening’ its business to make it more attractive to businesses and consumers.

If you do nothing about the energy used to keep these servers cool, you are using a massive amount of carbon. Indeed, many have suggested that the carbon used by such businesses puts the environmental impact of transport in the shade. The size of the cloud sheds used by Digital Realty’s largest clients – tech giants such as Facebook and Google – is extraordinary.

Facebook asked Digital Realty to use renewable energy for all of its servers. And that is precisely what the company did. This represents a big step up. All of its businesses in Europe, the Middle East and Africa are now supplied by renewable energy, along with much of that in the UK. It has said to its customers: “We’ll host your servers, we’ll provide you with a fridge, but the fridge will be powered by renewable energy.”

This is a really interesting dynamic. Two years ago if you’d looked at Digital Realty, you wouldn’t have seen much in the way of green credentials. But the company now understands that if consumers are changing their attitudes, suppliers need to change too.

The renewable-energy opportunity

At the moment, some of the most attractive investment opportunities centre on renewable energy – the ‘E’ bit of ESG. One good example is Cadent, better known as the owner of British Gas. The UK government has said to Cadent that it wants to decarbonise liquid natural gas (LNG). One of the best ways of achieving the UK’s Paris targets is to decarbonise the natural-gas energy used by households up and down the country. Cadent is looking at putting hydrogen into the LNG supply. So you might have 70–80% LNG and 20% hydrogen. Existing boilers can cope with that. Cadent is also looking at making the boilers themselves come off LNG and move to electric. Much of that can be supplied by renewable energy in the UK – wind and wave farms, for example. This has an impact on how long we are prepared to be exposed to Cadent; given the likely ramp-up in capital expenditure connected to decarbonisation, we have limited it to the mid-2020s.

A changing world

So, rather than simply investing in ‘green bonds’, we want to invest in companies that recognise that the world is changing around them. We believe the drive towards environmentally friendly outcomes is irreversible and that companies that realise this will be rewarded. Even the airlines are taking action, in reaction to the recent trend towards ‘flight-shaming’. Ryanair has focused more on its environmental approach (although we are still working through what it is doing to see if it is enough to make a difference). IAG – the owner of British Airways – has started to use biofuel mixed in with its aviation fuel. Some companies are dealing with this better than others. Our task, then, is to find the companies that are doing best in this regard. If we like the rest of their businesses, we invest as an ‘upping quality’ trade.

But ‘upping quality’ can also mean buying the lowest-rated bonds from the best banks. That means we are upping the quality of the yield. This can mean upping the quality of the company’s engagement with the environment. It can mean upping the quality of the governance of that business. Or it can be going out and buying more single-A businesses that we like.

Another form of ‘upping quality’ involves reducing our energy exposure. Although we have been very keen on energy as a sector in recent years, carbon-energy use is declining. And with the huge growth in fracking in the US in particular, the global power base has shifted from Saudi Arabia to the Permian basin in Texas. While the West Texas and Brent crude prices are back at nearly $60 a barrel now, if we are right about the end of the economic cycle oil price, this is not an area of the market to be in. That’s because economic growth is no longer likely to support the oil price – and because the International Energy Agency itself is projecting a decrease in the use of carbon fuel.

Every downturn is different, whether it is caused by a crisis or a more traditional end-of-cycle recession. This time around, we could be entering a recession with record employment levels. That would leave the consumer as a powerful force in the economy – a force that is changing what it demands from companies.

So, rather than focusing on the negative yields that appear to be pointing to the next downturn, we want to harness the forces that are shaping a rapidly evolving business environment. Consumers and their ESG concerns are likely to be prominent among those – and we are positioning our portfolios to reflect that. 

Written by Luke Hickmore, Senior Investment Manager, Fixed Income - EMEA