Some investors will happily pay to lend

28 August 2019

Unless you are a parent with deep pockets or are fortunate enough to have a money tree, you probably expect to get back any money you lend to someone – and maybe a bit extra as a thank you. 

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Bonds

That’s certainly the expectation of bond investors: they lend money to a government or company and, in return, receive a regular income until the loan is repaid.

But that’s not happening at the moment. Low interest rates and a 35-year-plus bond bull market [where bond prices are high and yields low] have resulted in $13 trillion* (£10 trillion) worth of bonds trading at ‘negative yields’: investors are actually paying for the privilege of lending their money to institutions. The situation is more acute in some countries than others. Chris Garsten, manager of Waverton European Capital Growth, says 51% of all eurozone government bond paper now has negative yields.

Central banks in the US and Europe have hinted that interest rates may be cut and quantitative easing deployed again, meaning that money will once more be injected into the financial system to keep economies on track. Sweden and France have joined Germany, Switzerland and Japan in the 10-year government bond ‘sub-zero yield club’.

And it’s not just government bonds that are trading at negative yields. A fifth of European investment-grade debt [loans to companies] are also in negative territory. What’s more, several European high-yield bonds are now trading at negative yields. The high-yield from such bonds is supposed to compensate investors for the extra risk they are taking. The bond world seems to have gone a little crazy.

Why invest in bonds with negative yields?

So why would someone invest in a bond with a negative yield? Well, there are a number of explanations.

First, ‘forced’ bond buyers and sellers have no choice but to trade: life insurers and pension funds that track the bond indices, for example, and central banks under pressure to buy their home county’s or region’s bonds to support their economies.

Secondly, when the yield on a bond falls, its price rises, so a buyer may think they can sell it to someone else at a higher price later on if yields decline further.

Thirdly, bonds retain the allure of a safe-haven asset. Most bond market investors would agree that they are highly likely to get their get money back, although they may get slightly less than they initially invested. But is a guaranteed small negative return on an asset held for 10 years too high a price to pay today for this perceived safety?

Thankfully, the bond universe is a big one. The $13 trillion of bonds trading at negative yields sounds dramatic, but they represent just about a quarter* of the bonds available, so there are still plenty of opportunities to find decent income.

Plenty of positive yields to be found

One bond sector unaffected by negative yields is emerging markets. In terms of 10-year government bond yields, Mexico and Brazil come top, with 7%-plus** yields, while India isn’t far behind with a yield in excess of 6%**.

One fund I like in this area that can take advantage of these higher rates is M&G Emerging Markets Bond, managed by Claudia Calich. Its largest holdings*** include bonds in Brazil, Indonesia, Peru, India and even Rwanda, all of which yield between 6% and 10%. The risk when investing in emerging markets is high, however, so it’s not an investment for everyone. The higher yields do, though, compensate investors for the heightened risk.

For investors who prefer developed markets, the Aviva High Yield Bond fund is an option. Manager Chris Higham has recently been taking advantage of a Brexit-linked anomaly: debt issued by European and US companies in unloved sterling produces much higher yields than debt in euros or dollars – simply because no one wants sterling assets at the moment. By owning a company’s debt in sterling, you get a better income return.

If you want the best of all worlds, TwentyFour Dynamic Bond can invest in any type of fixed income. It currently has 30%^ in government bonds, 25.6%^ in bank bonds, 13.5%^ in European and US high-yield bonds, 11.1%^ in asset-backed securities and 6.8%^ in emerging market bonds.

*Source: Goldman Sachs, based on the Bloomberg Barclays Global Aggregate Negative Yielding Index and the Bloomberg Barclays Global Aggregate Index

**Source: Tradingeconomics.com

***Source: FE Analytics, as at 31 May 2019

^Source: Fund fact sheet, 28 June 2019

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change. Darius’s views are his own and do not constitute financial advice. Mention of specific securities is for illustration purposes only and not a recommendation to buy or sell.

Darius McDermott is managing director at Chelsea Financial Services and FundCalibre