Commentary: Negative bond yields spell big trouble for institutional investors

Hindsight is an exact science, as English humorist Guy Bellamy noted. In hindsight, it's hard to disagree that the past four decades' economic policy has delivered a nirvana state for global bond markets. After spiking the federal funds target rate to 20% in 1980 to vanquish 1970s' inflation, the key policy rate has completed its cyclical decline to zero in the aftermath of the global financial crisis. Bond yields have followed and now sit at their lowest levels in the post-World War II era.

Conveniently for bond investors, lowering rates has been the primary policy tool in achieving economic objectives such as maximum employment and economic growth during this run. This aligned bonds' total returns with the well-being of the broader economy. Now, however, after a decade where rates have been mostly stuck at zero, the backdrop for economic policy in the decade ahead looks totally different than prior iterations. Challenges include sluggish nominal growth, a return of inflation, an aging population and overhanging debt. Hindsight will reveal any shift in this alignment, and a change will seem obvious in retrospect. It's time for asset allocators to realize that this 40-year alignment between bonds and economic policy could have reached its turning point.

For the optimist hoping to witness the prolongation of the greatest bond bull market in history, the apparent path appears to run through a continued declining trend in interest rates. This scenario implies not only an extension of the downward pressure on yields out to further maturities, but also a likely movement of the U.S. Treasury yield curve into negative territory for the first time.

At first, this seems plausible. Many developed countries have already taken their yield curves negative over the past decade, and consensus so far suggests they have not met much harm. Markets have been willing to absorb bonds priced at negative yields: over $16 trillion of outstanding debt traded at negative yields by the end of 2020, according to a Bloomberg tracker. Having watched others take this first plunge, with the leap appearing safe, asset allocators might be complacent for what follows.

Bonds have historically played a key role in multiasset portfolio construction. Unique for their ability to reduce overall standard deviation in a portfolio, they've offered significant diversification benefits from their low, sometimes negative correlation with other asset classes. However, their contribution to the multiasset portfolio has gradually eroded since the 1980s.

To illustrate, consider a 40% allocation to the Bloomberg U.S. Aggregate Bond index in the popular 60/40 portfolio. Its bond allocation has seen a steady decline in its contribution to the portfolio's overall return, falling from 5.0% on average annually in the 1980s, to just 1.5% in the 2010s, whose decline is attributable to the ever-declining yields behind the great bond bull market: a fall from an average 4.3% annual yield return in the 1980s, to just 0.9% during the 2010s. That erosion in yield return has been partially offset by price appreciation, which — while more consistent than yield — has been smaller in magnitude.

Never in the past four decades has the contribution to return from bond allocations depended more heavily on price appreciation than in the 2010s. With yields on U.S. investment-grade bonds beginning this decade already below last decade's average, the outlook for yield returns to hold their ground looks bleak if the decline in rates continues. If allocators can't count on yield, allocators will have to rely on price appreciation to pick up the slack — but can they? Let's look at the bond math to fully realize the implications.

So far, our experience with negative interest rates has involved the pricing of bonds at values greater than the sum of their undiscounted future cash flows which the security is contractually obligated to produce. On their attributes, these bonds look like any other previously traded on the street: At the end of 2020, the average bond in Bloomberg's negative yield tracking index paid a coupon of 1.37% with a maturity of 4.65 years. And bonds traded in the market at a premium, which occurs frequently when a bond's quoted market yield is less than its coupon, have always existed. What's changed is simply the arrival of market participants willing to pay more for a bond than all the undiscounted cash flows it will ever produce.

What would it take to maintain price appreciation under this dynamic? Let's try to match the average price appreciation of 0.6% annually that U.S. investment-grade bonds delivered in the 2010s. For simplicity, let's take the average features of the tracking index and view them as a single bond — a 1.37% annual coupon, five-year (rounded up from 4.65), priced initially at a yield of -0.31%. After one year, we've collected our $1.37 coupon payment and our five-year bond is now a four-year bond. To see our bond appreciate in price by 0.6%, the quoted yield on our bond must now fall 55 basis points from -0.31% to -0.86%. Effectively, that means we need a buyer in the market to purchase our bond at a price that exceeds the excess we paid for it — above its undiscounted future cash flows – but now by an even greater amount. Fast forward to year four. Maintaining price appreciation has gotten progressively harder, as achieving the desired 0.6% price appreciation now requires our bond to price at a -8.77% yield. Finally at the bond's maturity in year five, the end game finally arrives: some unlucky bondholder receives $100 plus coupon at maturity, for a bond acquired at $111.11 a year ago. Thanks for playing.

Over the full life of any bond, the only available return is its yield. Gains and losses booked as the bond trades hands is a zero-sum game once the bond reaches maturity. Therefore, it's inescapable that for bonds priced at negative yield, someone at some point must absorb the loss that arises from the upfront problem: that a bond was purchased above its undiscounted future cash flows. For allocators looking for direction, staying on the path offered by negative interest rates leads to worse than a dead end. The road leads to capital destruction.

The farther allocators travel in this direction, the harder it becomes for bonds to serve their legacy purposes of diversification, income and capital preservation in a multiasset portfolio. The best allocators will see and prepare for what's ahead, and differentiate themselves by solving the challenges to diversification and downside protection in new, bold and creative ways. In the meantime, bondholders must realize we're fast approaching a point where their interests are misaligned with the realities of zero-to-negative interest rate policy, maybe even past that point. It will all be obvious in hindsight.

Matt Dines is co-founder and CIO of Build Asset Management, which specializes in fixed-income and options strategies, based in Seattle. This content represents the views of the author. It was submitted and edited under Pensions & Investments' guidelines but is not a product of P&I's editorial team.