Central Banks' Frankenstein Bonds

Central banks have distorted markets without demonstrating any upside.

Good luck trying to find a debt investor who views negative interest-rate policies in a positive light.

More often than not, words like "scared," "cautious" and "worrisome" are used to describe reaction to a distortion of markets that is defying conventional investing logic. As BlackRock CEO Larry Fink put it in a recent article, "Let's be clear: Negative interest rates are terrible."

This fear and concern have taken on new urgency in the past few months after Japan jumped on the bandwagon with a negative-yield policy in January. While European central bankers first started experimenting with this tool in 2014, the volume of such notes has ballooned in recent months, now accounting for more than 46 percent of all non-U.S. sovereign bonds, according to an analysis by Jim Bianco, president of Bianco Research in Chicago.

"We're making this leap into this unknown and we're trusting that it's all going to work out,'' Bianco said in a phone conversation on Monday. He compared the negative-yield project to the creation of Frankenstein's monster.

It's as if central bankers are saying, "We're doing it because we can," Bianco said. "Well, should we? I don't know."

So what distortions are investors looking at that gets them all worked up?

First of all, a $23 trillion index of developed-market sovereign bonds is yielding less than 1 percent on average, near the record low of 0.75 percent in February, down from almost 4 percent in 2007. In some cases, funds are charging bigger management fees than yields on the debt they own.

Zero-Sum Game

Yields on sovereign bonds globally have plunged because of unconventional monetary policies

Source: BAML index data

And then there's the fact that Japanese investors are getting so desperate to move their money out of their country that they're paying big premiums to borrow U.S. dollars. Those payments have become so large that it's actually become profitable for foreign investors to buy negative-yielding Japanese securities based on the currency swap, as Bloomberg News reporters Kevin Buckland and Shigeki Nozawa pointed out. The consequences of an unraveling of this trade are unknown.

Meanwhile, investors are still trying to wrap their heads around even the concept of negative-yielding bonds. Theoretically, investors would lose money by holding this debt to maturity, but so far these notes have really just been bonds with zero or minimal coupons sold at a premium.

What governments haven't done is go the extra step of selling debt with negative coupons because that opens all sorts of other questions, Bianco noted. For example, how would a government round up all the investors in its negative-yielding debt to collect their coupon payments? What happens if the investors fail to pay the borrowing government in a timely manner? Is that a default?

The Federal Reserve has been looking at negative-yielding rates but has demonstrated little appetite for the measure in the world's biggest economy. European Central Bank President Mario Draghi hinted last week that rates in that region may have reached their lower bound. Bank of Japan Governor Haruhiko Kuroda has said there are no limits to how far central banks can ease monetary policy.

Sub Zero

Yields have gone even more negative on a swelling pool of sovereign debt

Source: BAML index data

Perhaps all the nervous debt investors are wrong and these groundbreaking tactics will save the global economy from what would otherwise be a paralyzing downturn. But the onus is on central bankers, Kuroda in particular, to show debt buyers how these policies will be beneficial.

While the Bank of Japan didn't lower the nation's interest rates further into negative territory this week, it may do so later this year. Kuroda said he doesn’t have to wait to see the full impact of the negative rate before his next move. 

For now, investors aren't convinced that this unprecedented policy is helping in any way, and it's hard to blame them.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the author of this story:
    Lisa Abramowicz in New York at labramowicz@bloomberg.net

    To contact the editor responsible for this story:
    Daniel Niemi at dniemi1@bloomberg.net

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