BONDS

Fear and loathing of negative yielding debt: bond investor’s dilemma

More and more, debt investors are being confronted by a new reality where deepening concern over the globaleconomy has made sub-zero interest rates the norm. In Germany, surging haven demand has pushed average yields onabout €1 trillion of debt below zero for the longest stretch on record. Bond prices are so high in Japan almost two-thirds of itsgovernment debt have negative yields. Benchmark 10-year securities in every G-7 nation yield less than2%. Even the yield on U.S. Treasuries is now at 1.77% after tumbling by about a half-percentage point this year. Thetraditional yield advantage that U.S. debt has enjoyed over sovereign bonds in Europe and Japan isn’t so clear anymore.

At a time when teetering financial markets have made security a paramount concern, investors are discoveringthere are few good options left. Even in the U.S., long the destination of choice in times of stress, Treasuries are in suchdemand that when their cash flows are converted into euros, yields are even worse than the scant returns on German bunds.For euro-based buyers of 10-year Treasuries, swapping the dollar interest payments into euros over the life the securitylowers the yield to 0.15%, according to data based on future expectations for interest rates and foreign exchange. That’s lessthan the 0.2% yield on German 10-year bunds. For Japanese buyers, it’s even worse. The same process results in a -0.7%yield in yen.

The effect is already playing out last month. While Treasuries have returned 1.2% in February, that translates into a lossof 0.4% in euros. In yen, the loss balloons to 6.6%. What’s more, hedging all the currency risk results in a return for eurobuyers that’s no better than just investing in German bunds.

This is quite a tricky situation. The risk of a selloff in safe-haven assets has increased as yields get lower andlower. While the trade-off of losing a little money for the security of owning government debt when things seem so gloomymight be a small one for conservative investors, there are considerable risks in the mean time.

Last year, fears of deflation and the ECB’s introduction of quantitative easing (QE) pushed the average yield on Euro-Area debt to a record-low 0.475% and sent those on German bunds toward zero.Then, in the months that followed, faint glimmers of optimism over the outlook the region’s economy helped spark asudden and violent reversal that caused yields to soar.By the middle of June, yields on longer-term German debt jumped more than a percentage point and left investors withan unprecedented 13% loss in the quarter.Now, while Fed officials have said any discussion of negative rates was premature, Chair Janet Yellen noted inCongressional testimony the central bank was taking another look at them as a potential tool if the economy faltered.Nevertheless, traders have all but abandoned expectations for the Federal Reserve to raise interest rates this year.

FEBRUARY 2016

The analysis of Thierry MassetRout has probably room to runFear and loathing of negative yieldingdebt: bond investor’s dilemmaGold plays best defence against shareslump in four yearsCash is king in developing nationsFinland is the new sick man of EuropeInvestment spending in the Euro-Areahas failed to recover

Despite those reservations, many investors have bought negative-yielding bonds in recent weeks, as there arefew alternatives. It’s a response to the extraordinary steps by the likes of the European Central Bank (ECB) and Bank ofJapan (BoJ) to push interest rates below zero and buy more government bonds as they try to jump-start their economies.Last month, the Organization for Economic Cooperation and Development cut its 2016 global growth forecast to 3% from3.3% in November, saying “financial stability risks are substantial.” A majority of economists in a Bloomberg survey also saynegative rates will be in place at the ECB until at least the first quarter of 2018 and at the BoJ until at least the end of that year.

Government bonds with ultra-low yields remain in demand also in reaction to worries over the economic health of Chinaand the U.S. - the world’s two main engines of growth continue to linger and increasing volatility throughout financial markets.

But that’s not all. The willingness of debt investors to effectively pay governments to borrow also reflects increasingscepticism of central bank policies and concern those very measures may ultimately do more harm than good to theglobal economy. Even after central banks around the world spent trillions since the financial crisis on quantitative easing anddropped policy rates below zero for about two dozen countries, the market’s outlook for inflation globally is closing in onpost-financial crisis lows. Low prices for stocks and commodities are damping inflation pressures and sending investors tothe relative safety of government debt.

In this context, long term bonds, also known as long duration securities, stand to benefit most if yields go on falling:10-year bonds in the Bloomberg developed sovereign gauge (+3.5%) outperformed (+10%, in euro, for the German bonds,+9% for the Japanese ones, +7% for the Belgian ones, or +6.6% for the US ones) since the beginning of the year.

2.1 “Peripheral” sovereign bonds in the Euro-Area: overweight (versus “core” sovereign bonds) =>

neutral

The European Central Bank (ECB) is investigating non-performing loans to tackle bad debt across the region, and a taskforce will propose follow-up action. Heightened concern about banks' bad loans and creditworthiness is stokingEuropean market anxiety.

In Italy, banks’ bad loans reached a high of €360 billion, with record low interest rates helping squeeze profitmargins.Credit investors seem to think there's reason to steer clear of Portugal, at least. The country's 10-yearsovereign yield jumped above 4%, from about 3% at the start of the year. The cost of protecting Portuguese debtagainst default also soared, exceeding Turkey and coming close to Russia. The slump comes as the European Unionconsiders Portugal's budget, having told the country to take steps to comply with debt-sustainability rules.

In this context, Euro-Area sovereign bonds in the periphery have underperformed in 2016, especially those issuedby Greece (-11%) and Portugal (-4.8%). In February, the Spanish and Italian sovereign debt have lost between 0.45% and0.70% in average.

Speculation that the ECB, led by President Mario Draghi, will expand stimulus has helped hand holders of Germansecurities a 4% return this year. Perceived to be among the safest sovereign debt globally, together with U.S. Treasuries,German bonds also benefited as falling stocks drove investors to seek havens, even as that meant sacrificing higher yieldson offer elsewhere.

More evidence of a slowdown in the Euro-Area economy (a composite gauge of services and manufacturing in the euroregion slid last month to the lowest in more than a year) should prove to be a boost for the region’s sovereign bonds asinvestors will expect Mario Draghi to deliver more stimulus and not disappoint them for a second time.

Traders are positioned for a monetary-easing bonanza judging from the pace at which euro-region bondyields are dropping to new lows. The amount of debt yielding less than -0.3% - meaning it can only becomeeligible for ECB purchases if policy makers cut the deposit rate - jumped more than one-third to at least $1.22trillion since the central bank’s January 21 meeting. That’s when Draghi signalled more stimulus may be in thepipeline. He told the European Parliament that lower oil prices and market turbulence might prod the ECB to take actionto revive inflation. This is how dovish rhetoric can bite. The market believes that the ECB will do more in March, hencesuch a high proportion is trading below the current deposit rate.A 10 basis-point cut to the deposit rate in March is almost certain, according to forward contracts. This move, if itcame, would free about $400 billion worth of debt for the ECB’s asset-purchase plan, based on the BloombergEurozone Sovereign Bond Index.

2.2 Emerging Markets (EM) bonds in hard & local currencies: underweight

The slowdown in China’s economy, the further weakening expectations on the yuan and other EM currencies, therising debt burden in EM and the plunging oil prices are crippling developing nations’ ability to borrow abroad. Inthis context, the investor sentiment toward EM debt is weakening as the regional slump is raising concern that more EMcompanies will struggle to service higher levels of leverage just as the Federal Reserve has started raising interest rates fromnear-zero.

The average yield on developing nation sovereign bonds posted the biggest increase in four years (4.5% to 5.3% fordebt in hard currencies since end October last year).EM stocks lost a combined €2 trillion during the last 10 months and price swings in EM stocks have nearly doubledsince mid-2014 amid concern the first interest-rate increase by the Fed in nine years could drain cash flow from riskierassets.Exchange rates in commodity-exporting nations from Brazil (-25% versus euro in 2015), Colombia (-21%), South Africa(-15%), Turkey (-13%) and Russia (-7%) led declines among 24 developing-nation peers (-15%) as raw-material pricesdropped sharply (-25%).

“BRIC” (Brazil, Russia, India & China) ratings action is probably the biggest risk for EM as a whole as demonstratedby the recent Brazilian “derating”. Seven years after Standard & Poor’s lifted the nation’s credit rating to investment grade,reflecting the rising influence of EM, Latin America’s largest economy has lost its vaunted designation. S&P’s decision to cutBrazil’s rating one step, to “BB+” with a negative outlook, underscores its worsening economic and political prospects, aswell as the troubles plaguing other developing nations, including China and Russia. Now, the country faces the deepestrecession in a quarter century, a growing budget deficit, a wide corruption probe and a fractured ruling coalition.

In this context, the EM sovereign bonds recorded since the beginning of the year a loss of 1.3% (in euro) for thedebts in hard currencies and of 2.6% for the debts in local currencies.

2.3 “Investment Grade” corporate bonds (ratings above or equal to “BBB-”): neutral

The outlook for corporate borrowers worldwide is the worst since the global financial crisis, according to Standard &Poor’s.

The proportion of issuers facing a potential downgrade at the ratings company surpasses possible upgrades by themost since 2009. S&P is considering cutting ratings at 17% of the companies it covers. That compares with possibleupgrades for 6% of issuers. The 11%-point gap is more than double the level in June 2014!On a regional basis, Latin America had the biggest gap, with possible downgrades exceeding potential upgrades byabout 35%. For the Asia-Pacific region, North America and western Europe, the gaps were about 10%. Globally, S&Prates 35% of companies at “B”, making it the most common grade. The rating is five steps below investment grade.

The corporate debt outlook has darkened because of slower growth in China and a commodity rout that’s cut pricesto the lowest since 1999. The slump has also driven corporate defaults to the highest since 2009 and led to investorsdemanding a 8.9% yield to hold junk bonds, the most in four years, according to Bloomberg index.

With the Fed now ending zero rate era — even as the ECB maintains a loose interest rate policy bias — the outlook forrisk assets is becoming more fragile. The speculation is that Fed tightening could prove to be a multi-standard-deviationevent for risk assets.

Higher government bond yields may see investors migrate up the quality curve as they become able to achievea given yield target in better-rated, lower-risk assets.Profit taking may become a theme in the high-yield space on the implied rise in corporates' debt-service costs,especially among those weaker-rated borrowers.Longer-term, higher funding costs seem likely to fuel a rise in the corporate default rate, which again maylead to a moderation in risk appetite. Indeed, even before any move by the Fed, S&P data shows that the U.S.corporate speculative grade default rate rose in October to its highest level since 2012. If the rates outlook begins toencourage investors to exit high-risk positions, at a time of lessened market liquidity and the reduced ability of the sell-side to absorb inventory, the impact of such a selloff could make the recent volatility related to Volkswagen andGlencore look modest.

2.3 “ High Yield” bonds (ratings below “BBB-”): underweight

As investors only add solid names in portfolios, they are conscious that the riskiest companies are at risk amid signs of aslowdown in China and a deepening plunge in commodities. They are now clearly shunning the lowest-rated junk bonds.That is underscored by the extra yield that investors are demanding to hold “CCC” rated credits relative to those rated “BB”.This has jumped to the most in six years. By one measure tracked by Deutsche Bank AG analysts, the debt of the riskiestcompanies is selling off at four times the rate of the least-risky junk borrowers - a ratio that’s typically 1.6 times!

That explains why High Yield issuance have dropped 36% year-on-year as investors remain concerned that collapse

in oil prices will squeeze corporate cash flows, especially in the U.S. where the speculative grade default rate rose by50% to 3.4% end of last year, the highest since 2012, according to Standard & Poor’s.

Holders of speculative grade bonds have suffered losses of 5.7% (in USD) since the beginning of 2015 as the High Yieldmarket is bracing for a surge in corporate defaults that would exceed the most pessimistic forecast from creditraters.

A measure of distress in the market is suggesting investors have priced in a default rate of 4.8% during thenext 12 months, driven by commodity-based sectors, especially oil & gaz. Concern mounts that energycompanies that loaded up on cheap debt are going to struggle to refinance. Edward Altman, the New York University professor who developed the Z-Score method for predicting bankruptcies,says defaults will breach the historical high this year and the Fed is the "wild card" that has the power todetermine how quickly the current credit cycle ends.Unless there is a miraculous turnaround in oil prices there is likely to be a lot of defaults. The rating agencies’approach isn’t capturing the fact that a large part of the economy is far out of step with the overall picture of the market.At least 185 bonds issued by North American energy companies with an aggregate face value of over $80 billion aretrading with a risk premium (option-adjusted spread) of over 1,000 basis points, according to Bloomberg data. A bondwith a spread with Treasuries of more than 1,000 basis points is generally considered distressed (borrowers rated “B-”or lower with either negative outlooks or a strong possibility of further downgrades). The sector has already accountedfor a quarter of 102 global defaults recorded by S&P in 2015, the worst year since 2009.The last time junk bond investors had priced in so many defaults, it was 2011! The United States had just lost its“AAA” credit rating, Europe’s fiscal crisis was threatening to infect markets globally, and central banks around the worldwould soon begin pumping unprecedented amounts of cash into the financial system. As that largesse pushedborrowing costs to record lows, energy companies in the middle of a shale boom in the U.S. tapped into the cheap debtto fund their drilling operations. Oil and gas drillers issued $213 billion of junk rated bonds the past four years,increasing the share of energy company debt in a Bank of America Merrill Lynch index of junk bonds to 13% this yearfrom 9.4% in 2005.With oil (WTI) now just above $30 a barrel, or about 70% below its 2014 peak, investors are demanding moreyield to own debt of commodity related companies.

Oil’s falling amid mounting concern that a record global glut in the commodity will be prolonged after theOrganization of Petroleum Exporting Countries effectively abandoned its long time strategy of limitingoutput to control prices.The average yield on the debt of speculative grade oil and gas borrowers climbed to 18.3%, the highestsince the waning days of the global financial crisis in 2009 and the widest divergence ever relative to the broaderU.S. junk bond market.At the same time, half of the debt issued by speculative grade metals, mining and steel companies aredistressed. That has pushed the share of the bond market that is considered distressed to 15.5%, the highestsince 2011, according to S&P. That’s likely to push more companies to ask their bondholders to restructure debtto avoid bankruptcy.