No need to fear negative interest rates

Bond yields continue to fall and it is time to let old habits die. With the proper strategy, however, the asset class could also play an important role in the future, says Sven Langenhan, Portfolio Director Fixed Income at Flossbach von Storch AG.

Sven Langenhan

Interest rates are likely starting to cause concern for some investors. The yields on what are considered to be safe bonds are deep in negative territory. The risk premiums on poor quality bonds also recently recorded a significant drop. Here is a summary of the current situation:

  • . Ten-year government bonds currently have negative yields in around twelve OECD countries (at the end of August). This is also the case for the majority of government bonds from eurozone countries, with German government bonds even showing negative yields up to a maturity of 30 years.
  • . The “long end” in particular, that is, the yields on bonds with very long maturities, recently recorded another significant drop. The market therefore feels that negative interest rates will remain for a long time to come.
  • . The yield on Italian ten-year government bonds recently fell below the one per cent mark – and, therefore, below the rate of inflation in Germany and the eurozone. In contrast, yields were recently around 0.1 per cent at times in Spain and Portugal, and 1.7 per cent in Greece.
  • . This means that static investors – who only think in terms of yield p.a. – are guaranteed to see a drop in the value of their assets. The yield on an inflation-linked German government bond with a remaining maturity of around 27 years recently fell to minus 1.5 per cent. At these terms, the – at least inflation-protected – loss in value to the end of maturity is more than 35 per cent.
  • US Treasury yields also recently fell. When the costs of currency hedging are included, even ten-year bonds are no longer able to maintain their real value.
  • In addition, the yields on more and more corporate bonds are also becoming negative, including, for example, long-maturity bonds issued by major corporations.

    In our view, this summary, which is certainly incomplete, shows one thing in particular. Investors who hold good quality bonds in their portfolios until maturity “just simply” to collect the annual coupon are suffering losses in the real value of their assets. Years ago, these bonds stood for “risk-free returns”. This changed as a result of the historical low level of interest rates, with “buy and hold” quickly coming to stand for “return-free risk”. And now the end result of this strategy is a “guaranteed loss”. This also applies to passive bond investments, such as ETFs, which only track the market without actively trading in individual securities. According to a study by the Flossbach von Storch Research Institute, active bond managers were already able to achieve higher returns than their passive counterparts when the level of interest rates was significantly higher. Bond investors have no reason for resignation. In our view, bonds can still be attractive if a flexible, truly active strategy is used that takes advantage of all the return opportunities available in the almost EUR 80 trillion global bond market. Market movements can be opportunistically used, for example, such as when many investors move in the same direction. The asset class continues to offer a great many possibilities for active investors. They can choose between different maturities, debtor priorities, currency areas and interest rate areas, and can also actively manage portfolio duration. In addition, the active use of futures and derivatives can stabilise portfolio value and offer opportunities to generate returns. We feel that bonds continue to play an important role in preserving and increasing portfolio value over the long term. At least for those with a clear, business-oriented investment philosophy who are in a position to actively take advantage of opportunities that arise.