Bonds: From high yield to below yield

It is hard to think of a more bizarre consequence of quantitative easing (QE) than negative yielding high-yield bonds.

Indeed, it seems that the capital markets have entered their own Bizarro World, the comic book realm where everything is the opposite of what it should be.

Zero or negative yielding high-quality bonds have been a feature of the bond market for years.

Worldwide, $7 trillion of government bonds yield negative interest rates. In late June, the surreal prospect of the two-year debt of Italy – a country with a debt-to-GDP ratio of 132% and rising – turning negative became a reality.

Some €4.4 trillion, or half, of European government bonds offer a negative yield, as does 20% of European investment-grade debt outstanding.

But for high-yield issuers such as Altice, the French cable conglomerate with $50 billion of debt outstanding, to be offering negative yields on bonds issued by holding company Altice Luxembourg SA just defies all logic.

Investors are flooding the rest of the bond markets with liquidity and squeezing out any yield as a consequence 

In May, the issuer had to pay 10.5% to raise $1.6 billion via an eight-year deal, while at the same time having to offer an 8% yield to raise €1.4 billion euro-denominated bonds of the same maturity.

However, in June, when European Central Bank president Mario Draghi stated that cutting interest rates, or even restarting QE, was back on the agenda, the impact was baffling. Around 14 European high-yield issuers have subsequently been trading at negative yields, including Altice and market stalwarts Ardagh Packaging, Smurfit Kappa and Nokia.

Actually, how we got here is no mystery.

At the time of writing, the yield on 10-year German government bonds is 0.34% and the 10-year US treasury offers 2.096%, having dipped below 2% in late June for the first time since 2016.

Investors are, therefore, flooding the rest of the bond markets with liquidity and squeezing out any yield as a consequence.

According to Bank of America Merrill Lynch (BAML), inflows into Europe investment-grade credit funds in the six weeks to mid-July averaged almost $5 billion a week, which analysts describe as “way in excess of anything we have ever seen before and far above the weekly run rate that transpired post 2016’s CSPP launch”.

By July, $12.8 trillion securities worldwide were offering a negative yield, including roughly 2% of the euro high-yield universe.

“We estimate that this number would rise to 10% upon a further 35-basis-point decline in high-yield yields,” claim the BAML analysts. The effective yield on the ICE BAML Euro High Yield Index has fallen from 4.89% on January 4 to 2.89% today.

Impact

What is the impact of this?

Primary markets price off secondary levels, so could we see more issuers pricing new deals at negative levels? Only very high-quality corporate issuers such as French pharmaceuticals giant Sanofi have managed to pull this off, but maybe more will do so in future.

If corporates can borrow so cheaply, they don’t have to worry too much about what they are going to do with the money.

Some would argue that is a good thing as it will encourage them to invest. Anyone who still believes this after witnessing the last 10 years of refinancing, dividend recaps and share buybacks is really living in a comic book reality: they are far more likely to do this than invest in growth.

The question remains, however: will negative yields encourage malinvestment in very low return projects?

Banks can now fund business lines such as commercial and residential mortgage lending very cheaply.

On June 26, German lender Landesbank Hessen-Thüringen Girozentrale (Helaba) sold the first negative yielding covered bond since a Berlin Hyp issue in 2017. The five-year mortgage pfandbriefe, due July 2024, carried a 0% coupon and a reoffer yield of minus 22.7bp. This comes as just 15% of the stock of outstanding pfandbriefe currently trades with a positive yield.

Cheap funding might encourage banks to do more real estate and mortgage lending. That doesn’t always end so well.

Buy side

Why do investors buy negative yielding bonds, which – if held to maturity – are guaranteed to make a loss?

They certainly don’t want to. And, for this reason, issuers might be tempted to issue longer-dated deals just to be able to offer buyers a positive yield. This may hit volumes of short-dated new issues.

In the secondary markets it is a question of relative performance as opposed to absolute performance: even negative yields are attractive if they are better than sitting on cash and investors have mandates to fulfil.

But there could be greater volatility as buyers – who are effectively paying cash flow instead of receiving interest – will try to get out of these positions as quickly as they can.

So many bonds are now held in passive strategies that the impact on the exchange-traded fund (ETF) sector could be another area to watch.

ETF funds that track particular indices have to invest in those indices. Funds that track European government bond indices have to invest in European government bonds, half of which, as we have seen, have negative yields.

The yield of these ETFs suffers as a result. Investors in high-yield ETFs probably weren’t expecting this to become their problem, but – bizarrely – it looks like it will.

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