Sovereign Bonds – Stretched to the Limit

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by Pater Tenebrarum, Acting Man:

Anti-Vigilantes

We dimly remember when Japanese government debt traded at a negative yield to maturity for the very first time. This happened at some point in the late 1990s or early 2000ds in secondary market trading (it was probably a shorter maturity than the 10-year JGB) and was considered quite a curiosity. If memory serves, it happened on just one brief occasion and it was widely held at the time that the absurd situation of a bond buyer accepting a certain loss if the bonds were held to maturity was an outlier, never to be seen again. And this is what the world of bonds looks like today:

 

Sovereign debt with negative yields to maturity rises to a new record high of $15 trillion

 

As the chart indicates, a trillion isn’t what it used to be, since lately another trillion in negative-yielding debt seems to be added to the pile every other week. Falling inflation expectations, the widely expected resumption of “QE” by major central banks (chiefly the ECB), speculative buying and regulations enforcing financial repression have all combined to drive “investors” (we use the term loosely in this case) over the cliff into the realm of utter madness.

With respect to regulations and financial repression, Charles Gave of Gavekal Research related the following anecdote in a recent missive (hold on to your hat):

When meeting some clients a few weeks ago in Amsterdam, I made my usual remark about the stupidity of running negative interest rates. In response my host told me a sobering story. He manages a pension fund and had recently started to build large cash positions. One day he was called by a pension regulator at the central bank and reminded of a rule that says funds should not hold too much cash because it’s risky; they should instead buy more long-dated bonds. His retort was that most eurozone long bonds had negative yields and so he was sure to lose money. “It doesn’t matter,” came the regulator’s reply: “A rule is a rule, and you must apply it.”

Thus, to “reduce” risk the manager had to buy assets that were 100% sure to lose the pensioners money.

You can read the rest of Mr. Gave’s article here. As he points out, the long-term management of savings by pension funds, banks and insurance companies is essentially doomed to failure by negative yields. It cannot be otherwise: someone is eventually going to take the losses – that is an apodictic certainty. The only question is whether these losses will be incurred sooner or later.

A friend recently asked whether the situation depicted above should be considered the “new normal”. Historically, long term bottoms in interest rates have tended to be quite drawn-out affairs. As the case of Japanese government debt demonstrates (the original “widow-maker”, so called because it has destroyed countless traders who tried to bet against the uptrend in JGBs over the years), if a central bank is strongly committed to manipulating bond prices, they can trade at extreme levels for years on end.

 

JGB futures contract, weekly – the original “widow maker”.

 

Having said all that, we believe that negative-yielding bonds very likely do not represent a “new normal”, i.e., an immutable state of affairs that will remain with us forever. In fact, there are very good reasons to believe otherwise. First, here are a few more charts of major sovereign bonds and their yields:

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