Why so much interest in negative bond yields?

19 Jul, 2016

I thought I had experienced everything as an emerging markets investment manager in Europe but negative yielding government bonds are a totally new phenomena.

Very simply, when you buy a bond with a negative yield you are paying someone to hold your money. Effectively you get back less than you deposited. German, Swiss & Japanese 10-year government bonds all have negative yields. If you buy these government bonds today, then you are guaranteed to get back less than what you invested. A guaranteed loss doesn’t sound smart investing to me. However, US investment bank Merrill Lynch points out that there is now a whopping $11.9 trillion in government bonds yielding (interest received) less than 0%. This represents 29% of the total outstanding global government bonds (see below).

The good news for New Zealand Government bond investors is that yields are still positive with the 10-year bond currently yielding 2.3%.

Negative yielding government bonds

Source: Bank of America Merrill Lynch

The current investment environment is unique as when investors lend money to governments in the past, these governments would pay you interest for the privilege. When you lend money there is a risk you might not get repaid (as the Argentinian Government has done in the past) and there is the opportunity cost as you could have used the money for other purposes. But this is not the case today as some investors seem more concerned about the return of their money and not the return they receive on their investments.

So why are rational investors buying bonds with negative yields?

There are a number of reasons why government bond yields have turned negative, particularly the dramatic impact of Quantitative Easing (money printing) policies adopted by global central banks. There is also an argument that investors are rushing to safe haven government bonds because of concerns about the global growth outlook, slowing Chinese growth and geopolitical risks. Whatever the reason is, it’s hard to be particularly excited about these so called “risk free” assets. The dilemma for investors is where to find a source of income given the slim pickings in traditional asset classes, such as bank deposits and government bonds.

Given the measly returns on most government bonds, there is a strong argument that investors should look to quality dividend paying companies that provide a regular income (dividends) with the potential for that dividend to grow over time. This point is further reinforced when we compare global government bond yields to the global equity dividend yields in the chart below.

As highlighted in the grey line, while global government bond yields have plunged to 0.5% the dividend yield of global equity markets is now 2.6% as shown in the blue line in the chart. Relatively speaking, the case for dividend paying shares is compelling given the gap between the dividend yield on equities and the yields of Government bonds of 2.1% (2.6% less 0.5%) is now the widest in 60 years.

Global Government Bond yield versus MSCI World Dividend Yield

At a country level, it is interesting to note that dividend yields in most markets exceed the yield you would receive if investing in 10 year governement bonds (see table below).

In summary, it’s pretty clear where the opportunities are in investment markets and it’s not in negative yielding government bonds. Our focus is on quality dividend paying companies that provide a sustainable growing income stream. Assessing management is a key part of our investment process and our belief is that companies rewarding shareholders with a growing dividend is a sign of management quality as well as an indication of a strong profitable business. In the current volatile investment environment, we believe companies that combine strong cash flows with a steady stream of dividends are the place to be and are likely to deliver positive shareholder returns over time.

Stephen Johnston

Senior Analyst

July 19, 2016