Iain North of Aurum Funds asks whether it is right (or logical) to make investors pay for lending their money
Earlier this month, 9 April 2015 to be precise, Switzerland became the first country in history to auction off 10-year government bonds with a negative yield. The move, which was a defensive play as the country fights the risk of deflation, begs a far bigger question: is this the future for bond investing?
It is not the first time shorter term debt was issued at negative yields.
Last year Germany, Austria, and Spain sold bonds with negative yields, while earlier this year Sweden and Finland sold five year inflation linked debt, joining the Danish bonds that also have negative yields out to five years.
But let's think about this logically. Investors who have willingly purchased these bonds have locked themselves into a guaranteed loss over 10 years.
This is truly a remarkable development in money management, especially if you think that Japanese 10-year bonds have never offered negative yields and the country has been battling deflation for decades.
Deflation traders or currency speculators taking a view of the markets is understandable, but what is driving longer term investors – many of whom are pension funds – to buy these bonds?
In the 2000 cult film Dude Where's My Car, two party goers struggle to piece together the previous night of excess to find their car. And along the way, they exercise some dubious decisions making skills.
Is this what is happening? Are investors applying what could now be flawed logic?
Buying bonds with negative yields is a sign that investors do not think that an economy will grow in the short term.
As allocators continue to base their investment decisions on traditional portfolio theories (ones that force them to buy bonds that guarantee a loss) one must question the fundamental reasoning that has led to this unprecedented situation.
Highly constrained pension funds continue to apply dogmatic bond allocations practises to track various bond benchmarks.
These lead to bond auctions, such as the recent one in Switzerland, to be over-subscribed, irrespective of any future return on capital. Is it time to change these practises?
But even if investors start to consider this possibility in the wake of continuing interest rate cuts across the globe, and there have been numerous this year from Australia through India right to Sweden, what do chief investment officers and consultants turn to?
It would seem that they are running out of options for the defensive portion of their portfolios. "Dude, where is my yield?" is no longer a joke question.
With the possibility for rising yields in the not-so-distant future in the US, a valid argument for global unconstrained bond investing can be made.
Taking country versus country and active duration decisions should lead to higher quality portfolios in terms of a risk/reward perspective and allow investors to turn their back on loss-making investments.
Looking beyond just buying bonds there are other options.
Alternative fixed income and macro strategies that allow a manager total freedom to apply proven techniques to generate the consistent low volatile bond-like returns once enjoyed in a classic fixed income portfolio are among them.
Whatever the solution, changing the investment habits of a lifetime is not easy.
But is making a loss over a 10-year period really what most long-term investors want? If the answer is no then it is time to start on a new journey. As Lao Tzu, a philosopher and poet of ancient China, says "The journey of a thousand miles begins with one step." In this case, the first step is perhaps to ask, "Where is that yield going to come from?"
Written by Iain North, senior analyst, Aurum Funds.
