Is it worth paying for the privilege of holding government bonds?
We’ve all heard the phrase ‘cash is king’. It gets used a lot when investors think the prices of other assets are getting too high and they would rather sit on cash while waiting for prices to fall.
This is very much a ‘cash is king’ moment. We would argue that government bond yields are unsustainably low. Some $15 trillion of global debt is now trading with negative yields — yes, negative (figure 3). That means buyers of these bonds are paying for the privilege of lending money to the issuers of this debt. The return on their investment, if held to the bond’s maturity, is guaranteed to be negative.
Back in the day, before this ‘new normal’, if a borrower didn’t pay back the full amount of the loan that was called a default. Now it’s just called a negative yield. Central banks have cut so deeply into interest rates that there is nowhere else for them to go but to the subterranean territory of negative rates. You could argue this is default in a different guise. The big question is: how much lower can rates go?
The cost of carry
This brings us to what is known in the markets as the ‘cost of carry’. It’s the cost of holding an asset, including financial costs (such as interest rates) and storage costs (for example, to store commodities in a warehouse). If an asset has a negative yield, there is a large cost of carry compared to an asset that yields a positive return. At what point does it make financial sense to take cash out of the bank and pay to keep it in a safe deposit box?
At some point this will cost less than leaving the money in the bank at negative rates (which is actually happening in Switzerland and elsewhere where central bank rates are negative). At some point central bank rate cuts will start to become useless.
We may be nearing that point in Europe. That’s why outgoing European Central Bank President Mario Draghi’s parting shot was to call for fiscal easing (governments loosening their purse strings) to help economies; central bank stimulus could be at its limits.
Cash rates in the UK are still positive, albeit not that positive with the Bank of England base rate at 0.75%. This is well below inflation, eroding the purchasing power of cash deposits. But we would argue that cash is king in the UK right now too. Cash rates may be below inflation, but yields on gilts that mature as long in the future as 12 years are below cash rates (read more about this unusual inversion of the norm and what yields are telling us in ‘Revenge of the bond nerds’ on page 6).
The Brexit factor
We see risks that UK yields could rise (prices fall), for example if Brexit turns out not to be the unmitigated disaster for the UK economy that current ultra-low yields seem to be anticipating. Or inflation expectations go higher. At least you get some return for holding cash in the UK; government bonds — which yield even less — are an unattractive option. Of course, gilt yields could keep going lower (prices higher), but we don’t think the economic fundamentals are on their side.
With the global economy slowing, and an outside chance of recession, there may also be better opportunities for those who wait to invest their cash in assets that offer better returns.
Right now the additional return on offer for investing in corporate bonds rather than safer government debt is the lowest it’s been in about a year. That doesn’t square up very well with all the talk of recession risk — corporate bond markets seem to be taking a more positive view. Equity markets have also continued to rise so far this year, again defying recession talk for the moment. In both cases, these markets are vulnerable if recession does come, or even a deeper slowdown from what’s currently being experienced.
However, with yields so low or even negative, government bonds may not provide the diversification benefits they have in the past. To offset a big fall in stocks you need a huge fall in government bond yields to compensate for that risk. For reasons discussed above, that may not come through. Cash just might be king.