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Imagine a bank paying you monthly interest rate fees on your mortgage.

Dutch lender Achmea NV found itself in that very position earlier this year when it had to pay a homeowner for their variable-rate mortgage. The mortgage was set to a Swiss benchmark, and Switzerland’s interest rates had gone negative.

Thanks to the topsy-turvy world of negative interest rates, commercial banks in Europe and Japan are paying for deposits. Negative rates in these regions have affected yields around the world, pushing positive-yielding bonds into the red. As bond prices rise, their yields fall, and as of September, about US$11 trillion in bonds globally—mostly sovereign, but some corporate securities—were trading with negative yields.

For some, negative rates portend a coming economic crisis or slump, an environment in which investors are placing the return of capital above a return on capital. For others, they are a new normal amid seemingly permanent stagnation and slow growth.

For investors looking for returns, negative interest rates are puzzling. Should they buy negative rate bonds, ever? Where’s the bottom?

“If I had talked to you five years ago, and said that—in the bond market, or securities with a yield-to-maturity of greater than one year—more than [US]$9.5 trillion worth of debt would have a negative nominal yield, you would have laughed at me,” says Robert Pemberton, head of fixed income for TD Asset Management. “Today, that’s exactly what we face.”

In search of yield, investors are seeking long-term bonds, increasing their prices. Pemberton calls this a “shift in the term premium along the yield curve,” with higher demand for securities further out the term-to-maturities curve in Canada, the U.S., Australia, and to some degree, the U.K.

Lower indexes

Typically, fixed income portfolios are managed against benchmarks like the DEX Universe Bond Index (known in Canada as the FTSE TMX Canada Universe Bond Index).

Scott Colbourne, co-CIO and senior fixed income portfolio manager for Sprott Asset Management, says that, rather than aiming for yield and return against an index, he’s working with a more flexible mandate to provide unit holders with “real returns” each year after inflation, taxes and other fees.

“When you have a Canadian bond now yielding half a percent to 1%, and you take off inflation, you take off fees […] expenses and taxation, you’re talking about a fund that gives you a negative real yield,” he says. “What it says to people who have the flexibility is, ‘Maybe your benchmark shouldn’t be the DEX Universe Bond fund, or the Merrill Lynch High Yield index.’ Create your own index, and say, ‘I want this portfolio to give me a positive return after inflation, fees and expenses.’ ”

Aubrey Basdeo, head of Canadian fixed income for BlackRock, says he looks at whether a portfolio’s price volatility is higher than yield. If so, “the compensation you’re receiving for the risk you’re taking is inverted.” He adds: “You should always look to get a higher compensation than the risk you’re taking.”

Portfolio mixes

Over the next three to five years, Pemberton expects fixed income returns to be 2% to 3% and equities to be about 6%, before fees. Return possibilities, he says, will be “far more muted” than they were immediately after the financial crisis.

The problem for bond managers is that there’s less room for yields to go lower, but selling is how to earn capital gains. When a bond yield falls, its price rises. “If you want a 6% return in an environment where 10-year government of Canada bonds yield, say, 1% for easy math, you need yields to fall to about 30 basis points for you to get your income and your capital gains,” Pemberton says.

Pemberton’s favourite portfolio mix is a limited amount of cash and enough government bonds to provide liquidity for fast-arising opportunities, he says. He advises limited exposure to European credit, and only that “with positive nominal yields.” Currency hedging is also important to manage against fluctuations that can wipe out gains.

His fixed-income funds are overweight on investment-grade North American credit. Pemberton’s research team is scrutinizing consumer cyclicals, materials, telecom, pipeline and insurance companies for opportunities. He also sees potential, without taking on additional risk, in investment-grade private debt and in U.S. BB- and B-rated high-yield debt.

“We continue to be focused on delivering better, long-term risk-adjusted returns above the broad Canadian benchmark, and those targets haven’t changed as a result of the lower interest rates levels,” Pemberton says.

For Basdeo, flexibility means going lighter on interest rate risk. There’s plenty of room for interest rates to go one way, but not the other. “If I assume zero is the lower bound for rates, we’re not too far from zero, and the upside looks skywards,” he says. “It’s a really skewed outlook.”

Rate risk can be hedged by short-selling bonds. The BlackRock manager says a better balance may look more like 50-50 or 60-40 interest-rate risk versus credit risk, as opposed to 95-5.

Private debt

Colbourne, whose diversified bond fund performance is 4.2% per year over three years, holds U.S. high-yield corporate debt and some emerging market debt, such as Argentinian sovereign bonds. But he’s also looking for private debt deals, he says, such as non-bank lending based on receivables.

“It’s not always necessarily a risk. Private debt has substantially more security than other debt. Even if a company goes into bankruptcy, they have an ability to work out and recover money,” Colbourne says. The catch? “You have to be prepared to lock up your money for a longer period. You’re sacrificing liquidity by getting a return.”

Ian Struthers, partner with Aon Hewitt’s investment consulting practice, says demand for private debt is booming. The debt is typically priced as a margin on top of the government of Canada rate. But with more demand, that margin decreases.

“It’s actually hard to find companies that are issuing a lot. Certainly there’s lots of demand for it and lots of interest from investors,” Struthers says, noting that debt for commercial real estate and infrastructure projects is easier to find.

Private debt still carries risk, especially if surging demand means lenders have less bargaining power on terms for future deals. Hrvoje Lakota, investment principal for Mercer, says cancellation penalties can be great for the investor whose borrower backs out. For locked-down, fixed-rate deals, “cancellation penalties can be severe” for the borrower, he says.

Don’t buy negative

Unsurprisingly, none of the Canadian fixed income managers interviewed by AER say they would hold negative-yield bonds.

“We don’t touch that stuff,” says Walter Posiewko, senior fixed-income manager for RBC Global Asset Management. “I would argue there’s never a time when it’s appropriate for a bond that you’re going to end up paying to hold. The reason people buy them is because they’re forced to, or because they think yields are going to become even more negative.”

With rates so low, anticipating central bank actions is critical, as sudden interest rate hikes can mean paper losses for bond holders. The 2013 taper tantrum—in which markets suffered on indications that the Fed would tighten monetary policy—demonstrated that, in the low-yield universe, markets are ultra-
sensitive to sudden hikes.

But asset managers indicate they’re ready for the possibility that rising rates, mixed with low liquidity, could trigger a disorderly unwinding in the bond market. They expect any central bank hikes on faster economic growth to be gradual, anticipated and managed in advance.

Basdeo says low interest rates in Europe and Japan would temper any impacts of tightening by the Fed. “I can change my curve positioning,” adds Pemberton, and if growth does pick up, “that would be spectacular.”

Who buys negative rate bonds, anyway?

Aside from central banks, institutions with large capital preservation and reserve requirements are buying negative rate bonds.

That’s because they have to. Insurance companies and pension funds, even where interest rates are negative, must have a portion of their funds in safe securities. Pensions match their bonds to liabilities, and insurance companies need bonds in their reserves.

Banks also buy government bonds to meet liquidity and collateral needs, and central banks purchase bonds for their foreign exchange reserves.

These institutions are buying negative government bonds in regions where rates are negative: Japan, the eurozone, Switzerland, Sweden and Denmark.

Negative rates aren’t without drawbacks for these big, institutional buyers. For one, bank costs are higher. Negative rates have also contributed to a growing pension crisis, as the funds face multi-billion-dollar shortfalls.

Insurance companies, dealing with slower growth and negative rates, continue to grow their client bases, increasing their capital requirements. That’s creating pressure to hike fees and invest in riskier, yield-enhancing assets.

by Simon Doyle, an Ottawa-based financial writer.

Originally published in Advisor's Edge Report

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