Index managers are dealing with negative yields

Negative yields have upended non-U.S. and global fixed-income indexes, although they haven't stopped bond markets from rallying.

Fixed-income index fund managers hold negative-yielding securities “to an extent consistent with the proportion of negatively yielding securities in the index,” said David Blake, London-based director of international fixed income, Northern Trust Asset Management, which manages $398 billion in fixed-income assets, in an e-mail.

“From a benchmark perspective, approximately 25% by market value of the Barclays Global Aggregate index presently consists of negative-yield issues,” Mr. Blake said.

“In contrast, virtually none of the Barclays U.S. Aggregate index consists of negative-yield securities,” he said.

Thierry Adant, senior investment consultant, Willis Towers Watson PLC, New York, said, “Global aggregate or global sovereign bonds or global corporate bond index funds will have significant exposure to European markets, anywhere from 20% to 30%, and I would suspect a good amount of those assets will be either at zero or negative yields. The way those indexes are constructed they just include all the instruments in the universe.”

For “passive index funds, unfortunately their mandate is quite strict,” Mr. Adant said. “So they have to follow the index, and the index has bonds with negative yields.”

The negative yield trend hasn't spread to U.S. fixed-income indexes. And so far, the negative yields appear to have little impact on U.S.-based asset owners, said Eileen Neil, managing director, Wilshire Consulting, Santa Monica, Calif.

“It's important the distinction is that the negative yields are outside of the U.S. and ... are in sovereign debt,” Ms. Neil said.

Non-U.S. developed market “sovereign debt is not utilized to any great degree by U.S. plan sponsors from a strategic perspective,” said Ms. Neil. “Only 2% of institutional assets in the U.S. are in non-U.S. bonds.” In aggregate, corporate and public defined benefit plans allocated, respectively, 1.2% and 2.2% of assets to the combined category of global and international fixed income, including emerging markets debt, as of last Sept. 30, according to Pensions & Investments' annual survey of the 1,000 largest retirement funds.

U.S. assets owners have tended to steer away from them “because they have always been lower yielding relative to U.S. securities, particularly when you factor in the cost of hedging” currency risk, Ms. Neil said. “Non-U.S. bonds tend to be fairly fully hedged or the hedge tends to be very high. So that's a big factor to why U.S. plan sponsors have not really had big exposure to (non-U.S.) sovereign debt.”

Mr. Adant added, “In the U.S. we haven't seen a need for action yet because they (institutional investors) haven't been impacted by” negative yields.

In all, $11.4 trillion in investment-grade sovereign debt globally traded in negative yields as of Aug. 2, according to an Aug. 10 Fitch Ratings Inc. report. That amount represents 33% of the $34.4 trillion total outstanding investment-grade sovereign debt market. The latest figure on negative yielding debt fell from $11.7 trillion on June 17, based on the Fitch data.

Northern Trust's “High Quality Euro Government Bond Fund shows holdings in line with the index producing an overall yield of approximately -0.17%,” Mr. Blake said. “To avoid lower yielding securities in preference for higher rates would result in poor positioning (from the index) from a portfolio construction perspective.”

“Despite the considerable proportion of negative yields, there are no negative coupons in the Barclays Global Aggregate index,” Mr. Blake said.

Messrs. Blake and Adant said no bonds with negative coupon rates have been issued. Instead, they said, issuers sell bonds with a zero coupon.

Such a bond produces “a negative total return ... for investors to lock a loss if they hold it to maturity,” Mr. Adant said. “Effectively you get a negative total return but it's not derived from a negative coupon. It's derived from a zero coupon and getting issued at a price which provides for a negative total return.”

“Some corporates in Europe are trading in negative yields, which is mind blowing,” Mr. Adant said.

The Fitch report noted that in Japan, $32 billion in bonds issued by Japanese financial institutions and corporates were trading with negative yields as of Aug. 2, representing 5% of the Japanese corporate bond universe.

“We have definitely seen borrowing rates collapse in Europe in particular, but companies are not yet getting paid to borrow,” Mr. Adant said. “They are still paying something.”

Still, even negative-yield bonds attract institutional investors and can serve a purpose in a portfolio.

“Clearly there are many reasons why investors might wish” to invest in negative-yield bonds, Mr. Blake said. “Liability matching, regulatory requirements, relative value, scarcity and long-run views on growth and inflation are just some of the reasons we continue to see buyers of negatively yielding securities.”

“A negative yield at purchase does not necessarily mean a negative return, if not held to maturity,” Mr. Blake said. “The investor may be able to sell the negative-yield bond at a higher dollar price than what was paid, i.e., an even more negative yield.”

Mr. Adant added that “yield curves have rallied. The long end has rallied a lot” as the yield curve has flattened. “Returns have been quite strong. Foreign exchange depending on your base currency has been a headwind or tailwind.”

“Credit spreads are tighter,” Mr. Adant said. “There has been a melt-up in risk assets particularly in low-rated credits. So high yield has posted a phenomenal return year-to-date. They are up 12%. So far it has been really good for bonds this year.”

Returns have been good because rates have gone down further, rallying prices.

“Bonds with low yield have very, very high convexity, which means for every basis point they drop they increase exponentially, more than linearly,” Mr. Adant said. “So (institutional investors) have harvested good returns.”

But the performance outlook appears more challenging.

“Going forward, given the starting yield is very low, you definitely are betting on either more quantitative easing (by central banks to stimulate economic activity) or you have to have a different reason for buying these bonds” than hopes of more double-digit return, Mr. Adant said.

“The more (noticeable) changes we see as a result of negative yields have been in active (fixed-income) funds,” Mr. Adant said. “In order for them to (justify) fees they have to take even more risk. That means going down the credit curve, taking more credit risk” such as “investing in high-yield bonds or higher risk credit assets as well as buying longer bonds and going out the yield curve in order to pick up a positive yield.”

Portfolio managers in European investment-grade credit securities “tended to use high yield ... as a tactical and not strategic” allocation, Mr. Adant said. ”Now we commonly see European investment-grade credit mandates run anywhere from 5% to 15% to 20% structural exposure to high yield because they need to make up for the low yield in the rest of the market.”

In sovereign debt in terms of maturity, “In certain markets, you have to go out more than 10 years tin order to harvest a positive yield,” Mr. Adant said.

Negative yields in German sovereign bonds extend out 13 years in maturity as of Aug. 2, according to the Fitch report.

The added risk “is not de minimis,” Mr. Adant said. “It is material the amount of additional risk (portfolio mangers) have to take in the current environment to harvest a positive yield or generate an outperformance,” Mr. Adant said. “They have to rationalize their fees.”

“We have had discussed with many managers (the potential) to reduce fees just to acknowledge that there is less total return available and even less ability to generate outperformance in certain markets,” Mr. Adant said.