Sub-Zero German Yields Risk Creating Vicious Cycle for Investors

  • Prospect of no return has some balking at negative yields
  • More than half of German bonds already ineligible for ECB QE

The rally in Germany’s bonds is creating a headache for investors.

The yield on the nation’s 10-year bund dropped below zero for the first time on record on Tuesday, leaving some investors balking at the lack of return on offer for holding Europe’s benchmark securities. Meanwhile, the surge in bunds has pushed yields on more than half of the $1.13 trillion Bloomberg German Sovereign Bond Index below the European Central Bank’s minus 0.4 percent deposit rate, making almost $626 billion of the bonds ineligible for its quantitative easing plan.

That risks creating a scarcity of bonds for the ECB, forcing it to purchase a higher proportion of longer-dated securities, and in doing so push down yields further, according to BlueBay Asset Management LLP. That will require investors to accept ever lower yields for the privilege of holding the debt, seen as a haven in times of turmoil. German bonds due in more than 10 years have returned 15 percent this year, according to Bank of America Corp. indexes, compared with a 0.2 percent return for shorter-dated debt.

“Central banks have become dominant players in bonds in order to fulfil their economic objectives,” said Salman Ahmed, chief strategist at Lombard Odier, which oversees about $150 billion. “For investors, that is a serious problem. It means taking greater risk for very low returns in a stressed liquidity situation.”

Demand for German bonds has surged as polls showed the U.K. may be on course to quit the European Union following a June 23 referendum. The securities have also been the biggest beneficiary among major European bond markets of the ECB’s buying, according to Bloomberg World Bond Indexes. The ECB’s quantitative easing plan was boosted to 80 billion euros ($90 billion) per month earlier this year.

Gross Warning

Bill Gross, the manager of the $1.4 billion Janus Global Unconstrained Bond Fund, said in a tweet last week that central banks have created “a supernova that will explode one day.” In April 2015, when bund yields were also at record lows, Gross, a former chief investment officer at Pacific Investment Management Co., said the securities were the “short of a lifetime,” presaging a selloff which saw 10-year yields climb by more than a percentage point within two months.

While the current rally has thus far shown few signs of abating, some are questioning the wisdom of holding securities that appear to all but guarantee losses. In order to make any money, investors buying now will have to bank on offloading bonds in the future to another investor willing to accept even more negative yields.

“As a value bond investor, I find hard it to believe that anybody would own a bond with less than zero interest rate,” Kenneth Taubes, Pioneer Investment Management Inc.’s Boston-based head of U.S. investments, said in an interview with Bloomberg TV in London on Tuesday. “Every day you own a bond like that you compound a loss, and the only way to make money is when someone else’s willing to pay a higher price. So as a store of value I don’t see it as a very good investment, there are better investments.”

One of the alternatives for investors would be to buy bonds with longer maturities, according to Laurence Mutkin, London-based head of Group-of-10 rates strategy at BNP Paribas SA. This strategy was seen in Japan before, with the yield curve between 10- and 30-year bonds “collapsing” after Japanese 10-year yields went below zero, he said.

“With bund yields at zero, that is the time to buy 30-year Germany,” he said in an interview on Bloomberg TV with Francine Lacqua on Wednesday. Investors would likely “take an incremental duration risk rather than having to take those negative yields.”

‘Symbolic Manifestation’

Benchmark German 10-year bund yields fell to as low as minus 0.033 percent on Tuesday, joining Japan and Switzerland as major economies with negative yields that far out. It was little changed at 0.005 percent as of 2:07 p.m. London time.

“A minus in front of the interest rate is a symbolic manifestation of a world turning upside down,” Stefan Kreuzkamp, chief investment officer at Deutsche Asset Management, which oversees about $829 billion, said in an emailed note. “The evaporation of this reference distorts every single asset class.”

Germany’s longest-dated security currently yielding above the ECB’s deposit rate, which acts as a floor on purchases, matures in July 2022, while bonds due in August 2046 yield just 0.57 percent, according to data compiled by Bloomberg.

With so many German bonds ineligible, ECB “purchases are focusing increasingly on longer-dated maturities and with the volumes having been increased following the QE expansion in March, there is now something of a turbo-charged effect,” Mark Dowding, a London-based money manager at BlueBay, which oversees $58 billion, wrote in a note this week. “This is creating substantial yield curve flattening pressure and so, regardless of protestations about the ‘mad’ level of yields, the technicals driving the market remain the overriding driver at this point.”

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