Is the Eurozone heading towards a fate similar to Japan with sticky disinflation, negative interest rate, asset purchase extravaganzas? Can we still generate positive returns from the European sovereign credit markets with relatively low risk, in such a negative yield environment wherein almost 14.63% of bonds have a negative Yield to Maturity (YTM) (Out of which 73% of negative YTM bonds have been issued by Western European countries such as Germany, France & by Japan in Asia)?
Active management of bond portfolios can help us effectively navigate through this negative yield environment and generate better than expected returns on our investments. In order to select the optimal active bond management strategy for the European sovereign credit market and to learn how we as investors can leverage the same, we need to understand the fundamentals of the economic prospects of the nations in the Eurozone and how they might be in the same boat as the BOJ.
The “Disinflation” Era:
Both the European Central Bank (ECB) and the Bank of Japan (BOJ) are struggling through sticky disinflation with the CPI (Consumer Price Index) undershooting their 2% target for most of the past decade. In order to prop up inflation to healthier targeted levels of 2%, the BOJ & ECB both have implemented numerous & sometimes even outrageous policies which sound absurd at first such as negative interest rates, asset purchases (equity & debt), loans at ultra-favorable terms & last but not the least the “Yield Curve Control” by the Bank of Japan (BOJ).
Let’s dig a little deeper to understand how these policies affect the European credit markets and how can use them to structure our trade.
“I want to borrow money & want you to pay me for the same”
If I came to you with the above proposal, you would probably think I’m crazy to even think about it. For years, economists and central bankers have had to deal with the problem of Zero Lower Bound (ZLB) on interest rates, which in turn restricts the extent to which central banks can stimulate the economy by managing monetary policy by navigating interest rates.
To counter this problem, Haruhiko Kuroda (Central Bank Governor, BOJ) & Mario Draghi (President, ECB) implemented this novel idea of “negative interest rates”. Negative interest rate here refers to the deposit rate i.e. the return banks get on their excess reserves (IOER) parked with the central bank. The whole motive behind this move was to disincentive banks from holding excess reserves and extend more credit to the economy. They expected this policy to amplify expenditure, wages and hopefully inflation. However, due to ageing demographics, low business confidence, lower credit demand growth and shrinking bank margins, inflation expectations have been consistently anchored below targets.
“Sir, what would you like to buy today? Japan, please”
Since negative interest rates were struggling in the background, the central banks started buying financial assets such as equities & bonds from the secondary market in order to inject liquidity. The expectation was that if the central bank buys bonds from investors, investors will expend the cash received and there will be scope for higher inflation through higher spending as they likely won’t invest the proceeds in negative yielding instruments available within the country.
With these expectations, the BOJ (yellow) ballooned its balance sheet away to as much as 100% of GDP! ECB’s assets as a % of GDP (white) have also jumped from 20% to 40% in the last decade. So while the ECB and BOJ were filling the glass (economy) with their rich milkshake (money), the Fed (green) decided to switch off the tap and replace it with a straw. In other words, most of the liquidity or money injected through the above policy measures found itself gravitating towards the US which officially stopped it’s balance sheet expansion and in fact started to “normalize it’s balance sheet”, effectively withdrawing liquidity. This lead to lower spending in the European economy and thus a muted inflation print. The phenomenon is also known as the “Dollar Milkshake Theory”, but that’s a topic for some other post.
“Are you a control freak? BOJ is.”
So in order to have control over the yield curve (which in turn heavily affects borrowing costs and thus spending & economic activity through credit demand), you’ve flirted with negative interest rates, went on an extravagant asset purchase spree, but nothing worked. So what do you do now? You not only control short term borrowing costs but also the long end of the yield curve. BOJ anchored the short end around -0.2% and the long end around 0% with a +/- 0.1% range by claiming to buy unlimited quantity at the upper end, to keep interest rates low for long. They expected this to maintain the steepness in the yield curve which could help soothe banks’ declining margins as they could now lock in a better spread. It would also support asset prices and build consumer confidence.
Now since Draghi has been following the footsteps of Kuroda and is probably in the same boat as him, he also might consider pulling a YCC trick out of his hat considering the end of his asset purchase program in December 2018. He even announced the launch of TLTRO-III (Targeted Longer Term Refinancing Operations) in the March 7, 2019, monetary policy review. Both of which, could help maintain an upward sloping yield curve and low yields.
The biggest beneficiaries of the asset purchase program and TLTROs are usually the nations which have the highest holding the ECB’s capital key with Germany, France, Spain & Italy being the top contenders.
For those who aren’t aware of the TLTRO program, here’s a brief explainer from the ECB website.
Since Germany is going to be one of the biggest beneficiaries of TLTROs as mentioned earlier, we can expect further easing in the nation, while interest rate risk from hikes seems to be subdued for the rest of the year. (Interpreted from the market-implied probability of interest rate changes).
Since the setup for Germany is ready now, considering soft inflation, low-interest rate risk, upward sloping yield curve & negligible credit risk (AAA rated), we can employ a strategy known as “Roll Down” or “Rolling down the yield curve” to enhance our returns within a short horizon of 1 to 3 years rather than just blindly accepting a 0% or even negative YTM on short-dated bonds by just holding them till maturity.
The strategy involves the purchase of a bond with a maturity in the higher yielding section of the yield curve and selling the bond prior to maturity when it reaches a lower yielding section.
The strategy can benefit investors by providing:
1. Higher incremental income: Purchasing bonds with a higher current yield
2. Higher capital appreciation through liquidation: Depending on the characteristics of the bond, a capital gain or reduced capital loss
3. Diminishing bond price volatility: As the bond moves close to maturity, the duration (interest rate sensitivity) of the bond also reduces.
In order to demonstrate how effectively this strategy has played out in the past one year on the German Sovereign curve, we need to discover the steepest section of the yield curve as on 10th March 2018, which we shall roll down from.
Just from eye-balling, we can deduce that the 5Y Yield at 0.008% and 4Y Yield at -0.23% seems to be steep enough for our strategy. So according to the strategy we buy the 5Y German Bund on 10th March 2018 with a YTM of 0.008% and 0% coupon at a price of €99.958.
In our base case, considering no change in rates across the curve, the yield on this bond should slide towards -0.23% leading to a price appreciation of €0.992 or 0.9924% within a span of one year. However, due to changes in the yield curve, we may incur capital gains/losses. In our case, it is observed that the yield on the new 4Y German Bund has moved down further to -0.44%, leading to a total price appreciation of €1.86 out of which as we calculated earlier €0.992 is attributable to the roll down effect and the rest €0.87 gain is on account of the yields moving down.
Adversely, yields could move higher if global growth picks up and inflation/IIP data delivers a shocker. We can model these scenarios for the next year by estimating the volatility of interest rates and running a sensitivity analysis of our total returns to these yield curve changes. This interest rate risk can then be effectively hedged with Out-of-the-Money (OTM) interest rate options, thus, locking in an effective gain of close to 0.9924% (after deducting the option cost).
As we’ve seen with this example, it is possible to generate positive returns that outperform the broader market by playing with the yield curve dynamics. As they say, it’s all about finding positivity (returns) when you are surrounded by negativity (yields).
Note: This information has been provided by Harsh Shivlani (Department Head, Fixed Income & Derivatives, Finvert) and is for informational purposes only. It is not intended to provide legal, accounting; tax, investment, financial or other advice and such information should not be relied upon for providing such advice.