World says goodbye to negative-yielding debt
The world’s pile of negative-yielding debt has vanished, as Japanese bonds finally joined global peers in offering zero or positive income.
The stock of bonds where investors received sub-zero yields peaked at $18.4 trillion in late 2020 when central banks worldwide were keeping benchmark rates at or below zero and buying bonds to ensure yields were repressed. Now, as central banks rush to tighten monetary policy – according to Bloomberg, their average rate will peak at 6% in the third quarter before ending 2023 at 5.8%, the highest since 2001! – in the face of surging inflation, the total market value of negative-yielding debt worldwide dropped to zero (see the chart)!
Yields have jumped in Japan after the Bank of Japan (BoJ) surprised markets on December 20 when it doubled the yield cap for benchmark 10-year government bonds to 0.5%. As a result, the number of bonds with sub-zero yields in the Bloomberg index which tracks fixed-rate notes that have a maturity of at least one year shrank to zero. For memory, the number of bonds in the index peaked in December 2020, at more than 4,600!
Japan’s yields were the last to leave the sub-zero club because policy makers there had stuck for so long with ultra-loose settings brought in even before the pandemic. Investors are now betting the world’s last uber-dovish monetary authority is also inching toward normalization. In the U.S., the Federal Reserve raised its benchmark by 4.25% last year, the most since 1973, and the US 10-year yield is currently at about 3.6%. The European Central Bank, meantime, exited its negative-rate policy in July, followed by its counterparts in Switzerland and Denmark in September. As a result, negative rates across the euro zone have become a thing of the past, even on shorter maturity debt. German and French 10-year yields are currently at about 2.3% and 2.8%, respectively, a significant leap from having been around zero a year ago.
While trading in bonds is likely to be volatile amid economic data and central bank rhetoric, the bond market rally seems to have legs. Even if a recovery won’t be smooth with the threat of recession looming, the fixed-income market now seems to price much of the ongoing monetary tightening cycle. With inflation and interest rate shocks likely to dissipate, bonds could rebound during the first half of 2023. That is why we are no more bearish on this asset class, and we maintain our preference for good credit quality bonds (“investment grade”) over lower quality bonds (“high yield”).
- Governments and companies around the world are facing unprecedented costs to refinance bonds, a burden that is set to deepen fissures in debt markets and expose more vulnerabilities among weaker borrowers. A company looking to issue new investment grade bonds now would likely have to pay interest that is about 1.7% higher on average than the coupons on existing securities, after that gap surged to a record in recent weeks (see the chart). That means that high yield corporates will probably struggle to repay their debts and their ratings outlook will probably deteriorate as the chances of recessions mount – Moody’s predicts the default rate will climb to 4.9% (in its baseline scenario) or 12.6% (in a “severely pessimistic” scenario) by November of next year, from a forecast of 2.9% for the end of 2022. Furthermore, their risk premium has not widened as much as would normally be expected during this hiking cycle and not enough to compensate for the rising risk of default. That is why we remain cautious about high yield bonds.
- A contrario, high-quality debt has flipped the script to become one of the hottest asset classes in the market. Some investors are increasing allocations to blue chip bonds as the yield they can get just by holding the debt to maturity has reached its highest level since the global financial crisis. Close to 3.5%, global high grade bond yields now are where high yield rated debt was trading at the start of the year (see the chart). It is a major shift for the $55 trillion global high-grade market, which has suffered massive losses this year amid aggressive central bank rate hikes. The steep losses in investment grade bonds, despite their near-zero probability of default - their average five-year default probability is 0.04%, versus 0.02% at the start of the year -, has created one of the most favorable entry points in years. Even if credit spreads do widen in 2023, an almost-tripling in global investment-grade corporate bond yields in the past 12 months gives investor returns a far bigger cushion to absorb such a move.
- Furthermore, the current gap (1.2%) between the average yield on investment grade bonds (corporate & sovereign) and the average dividend yield for stocks in the MSCI World All Countries index, which is the widest since 2008 (see the chart), should be welcomed by investors (see the chart). In the US, where the rate hike is the strongest, the gap (2.8%) is even wider! The “TINA” (“There Is No Alternative”) mindset that has been dominating asset allocation over the past few years, favoring equities over bonds, is clearly gone now as bond yields look more attractive and as risks of recession are weighting on dividend expectations. Diversification has been challenging, with positive stock/bond correlations through 2022. But falling inflation should reverse this trend in 2023 and investors may want to add bonds to their portfolios for additional diversification benefits, in addition to the enhanced income and return potential that these assets can provide.