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Things that go bump in the night – Part 2

| August 26, 2019

Here is a follow up to last week’s rant about negative interest rates and what it means for governments and savers (In case you missed it, here’s a link to last week’s missive). This week I want to show you a chart (below) that shows the amount of negative corporate bonds. Over a trillion dollars are now in corporate debt that will lose money over their respective maturities – and don’t forget, that’s under the best circumstances. There is always the chance that the company could go out of business or default on their bonds, or that interest rates rise over the term of the bond (and bond math says that when interest rates go up, prices go down).

So let’s see if we can do some of that aforementioned bond math just to show you how insane things are. We will use German Bunds for this example, but every negative yielding bond will look roughly the same.

Germany just issued 30-year bonds with a face value of $869 million Euros (that’s how much money investors will get back when the bonds mature). The amount that investors paid for those bonds was $898 million Euros. Here’s where the tricky math comes in.

German 30-year bond with a coupon of 0.0%  - yield to maturity -0.11% compounded over 30 years.

€898,000,000  (price paid)

€869,000,000  (maturity value)

€29,000,000  (capital loss on the purchase)

€                  0  (income from the bonds)

€29,000,000  (total net loss from the bonds)

That loss is only for “investors” who hold that bond until maturity. Remember, if you sell the bond prior to maturity, you will sell it for whatever the current market price is. That brings another risk into the purchase. If 10 years in you realize that inflation is higher and there are better investment opportunities elsewhere and you want to sell the bond, it is likely that the market price of the bond is significantly less than what you paid for it. Let’s look at that math for a minute.

German 30-year bond with a coupon of 0.0% - rates rise to 1%

€898,000,000  (price paid)

€718,000,000  (assumed market price in 10 years)

€180,000,000  (capital loss on the purchase)

€                    0  (10 years of income from the bonds)

€180,000,000  (total net loss)

Under this circumstance you can expect to earn -20% over those 10 years, and that is only if interest rates go up to a still paltry 1%.

According to Hans Mikkelsen, credit strategist at Bank of America Merrill Lynch, of all global investment grade debt delivering any yield, 95% is from the U.S. That means that much of the rest of the debt across the globe is zero or negative rates.

Like Wayne Gretzky, the only way to score a goal is to skate where the puck will be. In the investment world, you also need to look at the potential outcomes and base today’s decisions on the likelihood of all the good and bad outcomes over the time horizon of the investment.

I truly don’t know how any investor can justify deciding to buy a negative yielding bond, but maybe as rates in the U.S. get to those levels we will have to think hard about our choices. If the entire world is issuing negative yielding bonds, what do portfolios look like in order to achieve certain returns – the returns you need to make your financial plan work for yoiu? I think I have an answer for that, but I will save that for another time. One comment though, if that happens investors will be more and more forced into “risk” assets to get some sort of return, and that of course introduces a lot more risk than many are willing to take. Keep following our commentary as we will surely discuss this further.

We continue to be cautiously optimistic for the public markets, but the evidence is starting to accumulate on the side of the end game starting to play out.