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A lot has been written recently about negatively-yielding bonds, both by the press and by industry pundits. For the time being, this phenomenon is outside of North American markets. But it could come closer to home, according to luminaries like former Fed Chairman Alan Greenspan, who recently predicted that it’s only a of matter of time before negative rates spread to the U.S.
To better frame our perspective, it’s helpful to revisit how Pender thinks about risk. To summarize, we believe real investment risk is two-pronged – the risk of permanent loss of capital and the risk of an inadequate return. At the end of August 2019, roughly 30% of the bonds issued by governments and companies worldwide were trading at negative yields, or about $17 trillion of outstanding debt. This number had nearly tripled since October 2018.
Holders of such securities are promised a return of less than nothing, if held to maturity. Absent the use of derivatives1, the result could be both a permanent loss of capital and a negative return for the long-term investor. The Merriam-Webster dictionary defines investment as the outlay of money usually for income or profit. Perhaps we are too old fashioned in our definitions of investment and risk, but only by loose definitions could one call a security that guarantees you a loss an “investment.”
Why “invest” for guaranteed loss?
At one extreme, some have rationalized today’s negative yields by arguing that this is normal in a world of excess savings and wealth, and extended lifespans. This explanation relies on the theory that investors care little about return and are seeking safety instead. At the other extreme, some argue that today’s negatively-yielding bond markets mark the top of the bond bubble, not unlike the dot-com crash in tech stocks in 2000. In fact, the global bull run that began in the mid-’80s is now one of the most intense in the debt market’s 700-year history. Skeptics argue that the only reason to own negative-yielding securities is continued faith in the greater fool theory2, which works until the greatest fool finally buys in, which marks the top.
Who is buying such securities? And why? There is at least one specific group buying negative-yielding bonds – index bond funds such as the Vanguard Total International Bond ETF. This may have future ramifications for investors.
The virtuous cycle of easy monetary policy and low inflation following the 2008-09 financial crisis has attracted capital into sovereign bond funds at a furious pace. Trillions of dollars of capital have been created out of thin air by central banks. An ever-growing percentage of those bond market holdings are held by both retail funds and many institutional investors through low-cost, passive, indexed bond funds and ETFs.
As one might expect, the manufacturers of these index funds must do precisely what they say they will do as outlined by the terms of their prospectus. When there are inflows, they must buy individual bonds according to the weight in the index, regardless of price or future return prospects. Our sense is that a large proportion of bond buyers are probably buying index funds on autopilot, paying scant attention to yields. And as long as the price of the bond is going up, it is hard to argue against doing more of the same since the value of the holder’s account is probably going up.
This recurring pattern should not come as a surprise to anyone who has observed a market cycle or two. Incremental capital is usually attracted to what has been working best recently, but especially late in the cycle.
A memorable investment adage warns, what the wise man does in the beginning, the fool does in the end. Are the inflows to indexed bond funds primarily from the wise men seeking safety? Or from fools buying what has worked recently? Are we entering a new economic paradigm? Is it different this time? On balance, we tend to side with the greater fool theory, but we just don’t know for certain. Nobody does. Even the so-called “wise men” are very confused by today’s macro environment.
Only time will tell whether buying bonds at record low yield levels and record high prices will be a good investment. But as long as there are reasonable alternatives, we will pass on such securities. Investing is inherently a probabilistic endeavour. Periodic losses are an inevitable part of almost any investment strategy. But we strongly prefer to minimize loss when possible. Avoiding securities which are guaranteed to lose seems like a sensible plan. There are plenty of attractive alternatives available for investors who feel the same way.
Looking for yield, solid returns, downside protection
For example, we believe corporate bonds and preferred shares remain fertile hunting grounds for those seeking yield and solid total returns, while offering downside protection. In addition, durable and growing businesses that are able to refinance their debt at extremely low interest rates should be amongst the top beneficiaries of today’s low interest rates. Many of these companies have attractive dividend yields, often with potential to increase payouts over time, which is a great alternative for investors seeking income.
And let’s not forget that interest rates act like gravity on valuations. If interest rates are sustainably near zero, valuations can be almost infinite. In theory, this interest rate gravity should apply to all asset classes. But it hasn’t. Hence the opportunity. In our view, there are plenty of compelling stocks in different parts of the market worth considering. Many investors complain that the stock market is too expensive and they can’t find “cheap” stocks. That may be so, but perhaps they are just not casting their net wide enough. There is a world of opportunity beyond the attention-grabbing large-cap S&P500 stocks.
We do not normally delve deeply in macro-driven topics. We think macro factors are important, but largely unknowable. Instead, we spend the vast majority of our time on micro-factors trying to research and understanding individual businesses and securities. That is challenging enough! After all, individual businesses are complex adaptive systems that cannot be modeled with much certainty. Nevertheless, occasionally we uncover a few ideas that fall within our circle of competence, pass the scrutiny of our investment process and where the likelihood of a decent outcome seems favourable.
Our micro vs. macro view is probably best summed up by Charlie Munger, “Our job is to find a few intelligent things to do, not to keep up with every damn thing in the world.”
1. Through the use of sophisticated currency hedging derivatives, you can convert the low or negative yields into positive yields, but such financial alchemy comes with its own risks.
2. “The greater fool theory states that it is possible to make money by buying securities, whether or not they are overvalued, by selling them for a profit at a later date. This is because there will always be someone (i.e., a bigger or greater fool) who is willing to pay a higher price.” – Investopedia.com
Felix Narhi, CFA, is Chief Investment Officer and Portfolio Manager at PenderFund Capital Management. He works alongside David Barr, Pender’s President, in setting the direction of Pender’s overall investment strategy. This article first appeared in the Pender blog. Used with permission.
Notes and Disclaimer
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Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the simplified prospectus before investing. The indicated rates of return are the historical annual compounded total returns including changes in net asset value and assume reinvestment of all distributions and are net of all management and administrative fees, but do not take into account sales, redemption or optional charges or income taxes payable by any security holder that would have reduced returns. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. This communication is intended for information purposes only and does not constitute an offer to buy or sell our products or services nor is it intended as investment and/or financial advice on any subject matter and is provided for your information only. Every effort has been made to ensure the accuracy of its contents. Certain of the statements made may contain forward-looking statements, which involve known and unknown risk, uncertainties and other factors which may cause the actual results, performance or achievements of the Company, or industry results, to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements.
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