Aberdeen Asset Management Fixed Income investment manager Tom Laskey says:
“Returns on investments are always changing. You never know exactly what will happen, but markets try to settle on a fair price based on expected returns.
When you buy shares, you expect to be able to sell for a higher price in the future, or at least receive periodic payments (dividends). It’s difficult, but you can estimate an expected return. Bonds are similar, but you know the future price (when the bond matures) and the value of the periodic payments (coupons), so you can put a number on the expected return, known as the yield. The yield changes as the current market price of the bond moves around.
Given the inverse relationship between prices and yields, if the current market price of the bond goes up enough, the yield can end up negative. After years of increasing prices and falling expected returns on most assets, yields have turned negative on safe assets in parts of Europe. For example, Germany now sells bonds with no coupons for a price above the value at maturity. Investors do not have to make periodic payments to the German government, but in the end will get back less than they paid.
What explains this drop in expected returns? Most simply, a weak economy. The weaker the economy, the lower the return you might expect on all assets, especially the very safest. From this standpoint, low or negative yields reflect a gloomy outlook for growth in Europe.
The link between a weak economy and low expected returns happens for a couple of related reasons: central banks and inflation. One of the jobs of central banks is to keep inflation on target, but this is proving very difficult in Europe. Interest rates are being reduced to help boost the economy but inflation is staying low. In this environment, with low inflation unlikely to erode much of the value, safe assets are very attractive relative to others with much greater risk of losses.
However, it is still reasonable to wonder why an investor would want to buy a bond with a negative yield. Even if prices go up even further, returns are unlikely to shoot the lights out. But safe bonds will make up in security what they lack in yield. Consider some of the alternatives: hoarding physical cash, which would need to be insured; bank deposits, which run the risk of bank failure; foreign government bonds, which result in currency risk; or corporate bonds, which have default risk. There are few practical alternatives.
In fact the best alternative might be closer to home, in European bond markets. Prices currently suggest investors think the world will be a little healthier in a few years’ time than it is now. We can tell this because expected returns on longer dated bonds are higher than on shorter dated ones.
Prudent investment management is rarely about shooting the lights out. And if, as has been the case over the past few years, the market is too optimistic about the future, then these low yielding, safe assets may still prove to be a good investment.”