Prospect of negative U.S. yields on investors’ radar

Updated with correction

The U.S. Federal Reserve has pledged not to push its federal funds rate below zero as it struggles to revive a coronavirus-stricken economy, but investors may still want to game out how they'd respond if Treasury bond yields go negative at some point in the future.

The odds of U.S. Treasuries joining Japanese, German and other developed market sovereign bonds in negative territory, while low, have increased, noted Timothy F. McCusker, Boston-based partner and chief investment officer with investment consultant NEPC LLC, in a March report.

Ultimately, the coronavirus will decide whether rates will or won't go negative, according to an April report from Boston-based investment consultant Cambridge Associates LLC. "If the economic shock's depth and length demands even more monetary stimulus than is currently planned, then central banks that have previously resisted (negative interest rate policies), including the U.S. Federal Reserve and Bank of England, may be forced to reconsider," the report said.

Amid the ongoing fallout from the COVID-19 crisis, the yield on 2-year U.S. Treasuries stood at 0.147% on May 15, near the bottom of a 52-week range of 0.085% to 2.266%. The 10-year bond's yield came to 0.64%, toward the low end of a range of 0.38% to 2.442%.

"Given the importance of bonds and the reliance on them in investors' portfolios, it is important to consider this scenario and develop a game plan to manage assets" through unprecedented economic and market challenges, Mr. McCusker wrote.

Cambridge Associates offered similar advice: "It would be prudent for investors to begin exploring alternative insurance options, to understand their trade-offs and determine whether it makes sense to adjust or replace high-quality sovereign bond allocations in preparation for life after zero."

For market participants considering whether they need to diversify their risk-off exposures, the answer for many is "it's complicated" — as negative yields diminish some but not all of the charms Treasuries offer investors.

If the longer 5- and 10-year end of the Treasury curve sees yields go negative, U.S. public pension plans may have to change their thinking about bonds as income-producing and hedging assets, and rethink the composition of their capital preservation exposures, said Alex Pekker, a San Francisco-based managing director in Cambridge Associates' pension practice.

For corporate pension plans using corporate bond yields to measure their liabilities, the impact of negative Treasury yields would be more incremental, he said.

For public funds, it may be time to be a little more tactical, and consider adding exposure to "corporate bonds, other currencies or gold" as protective assets, Mr. Pekker said.

Even so, investors should retain some exposure to U.S. Treasuries as a source of liquidity and rebalancing, he said.

Some market veterans say a market with negative Treasury yields would be a very different environment for asset allocators.

"Once you go into negative rates … bonds are no longer bonds, they become insurance policies," said Mark Anson, CEO and CIO of Commonfund.

When an investor will pay $110 today for the assurance/insurance of getting back $100 tomorrow, fixed income changes from a strategic asset class to a tactical hedge, he said.

Commonfund had $22.6 billion in assets under management as of March 31.

But "paying for insurance is not novel," noted NEPC's Mr. McCusker. We do it in our own lives, in our businesses and, if the environment forces it, we may have to do the same in our investment portfolios," he added.

Others call the focus now on the "zero bound" for yields out of proportion to its importance.

"Negative rates get way too much press," said Eric Stein, Boston-based co-director, global income, Eaton Vance Management. "If you have a bond that yields 1 basis point or negative 1 basis point, that's only 2 basis points of difference" — nothing to even talk about but for the big deal everyone makes about the concept of negative yields, he said.

Eaton Vance had $436.8 billion in AUM as of March 31.

When it comes to bond yields, there's really no difference between 1 basis point and -1 basis point, especially "when we're talking nominal as opposed to real," agreed Eric R. Nierenberg, Boston-based chief strategy officer with the $76 billion Massachusetts Pension Reserves Investment Management Board.

“This distinction between nominal and real is not always fully appreciated," Mr. Nierenberg noted. "Hypothetically, if an investor believes that there will be 3% deflation, buying a bond at a -1% yield could make sense.”

Gregory Tell, J.P. Morgan Asset Management's New York-based head of its fixed-income investment specialist team, said: "There's no binary event that happens at zero." Plan sponsors will be more focused on "where we are in the market cycle," what they do on the way to negative rates and then what they should do after the economy bottoms and rates are set to head higher, he said.

Meanwhile, longer term, the enormous public expenditures being marshaled now to counter the crushing impact of the coronavirus pandemic on the economy will have to be financed by the issuance of new Treasury bonds — which all else being equal will push rates higher, Mr. Tell said.

Still, some market veterans say they don't feel particular pressure to consider those options at the moment. "In the U.S., you'd have to see persistent expectations of deflation for the market to make (negative yields) happen," and for now people expect inflation to remain positive, said Jay Love, an Atlanta-based partner and U.S. investment leader with Mercer LLC.

If, against expectations, U.S. Treasury yields go negative, effectively making negative yields pervasive for developed market sovereign bonds, one option NEPC says investors should consider is higher-yielding markets such as emerging market debt.

Gerry Fowler, Edinburgh-based investment director – multiasset solutions with Aberdeen Standard Investments, said the funds his team oversees have exposure to mainland Chinese bonds — with currency hedging costs offsetting the pickup the 10-year benchmark's 2.65% yield offers — anticipating gains as those yields trace the same path toward zero seen in other major bond markets. Aberdeen Standard Investments had $644.5 billion in AUM as of Dec. 31.