Tuesday, December 17, 2019

Negative Yielding Corporate Bonds

There are c.$13 trillion of negative yielding bonds globally. This accounts for 25% of all investment grade bonds. Please take a minute to digest this. Investors are willing pay $13 trillion for an investment that would not give them back their principal. This amount is a quarter of the bond market. This is the warped logic that the world of investing has come to accept.

It first started with sovereign bonds. When the ECB went into negative interest rates to boost the economy, the governments who could get away with negative bonds issued them ie Germany. Japan then followed suit. It was initially thought that the arrangement would be temporary, when the economy gets back in shape, we can stop. Well, we didn't.

The chart above from Bloomberg shows the magnitude and breakdown of negative yielding bonds. Today, corporates are issuing negative bonds as well. This is an excerpt from a reputable internet news source:

Siemens (SIEGY) borrowed €1.5 billion euros ($1.6 billion) over two and five years. Those bonds offered a zero coupon (interest rate) and were priced with negative yields, meaning investors are effectively paying to lend the company money if they hold the debt to maturity. The remaining €2 billion euros ($2.2 billion), borrowed over 10 and 15 years, offered tiny rates of interest. The two-year note, whose yield reached minus 0.315%, was "the most negative yielding corporate bond ever to be priced in the primary market," the source said.

As this went on, experts realized a few things about negative yields: it is like drugs or steroids. Once you are on it, it is very difficult to get off. It has certain positive impact but the side effects can be very bad. In finance, it was believed that negative interest rates would boost lending, force people to put money to work and hence bring the weak economies back to 2-3% growth. But instead, the side effects are manifesting.

Asset prices distortion: negative interest rates had brought down global returns. Recall the lessons in basic finance. Asset returns are based off risk free rate. This was the return on government bonds, usually the 10 year bond. It used to be 3%. After the Global Finance Crisis, it went down to 0-1%. Today it's negative! When the risk-free rate is negative, all the returns of the different asset classes are affected. Investors used to demand 8-10% returns on equity, maybe now they are happy with 5%. That is why we are seeing for 30-40x PE stocks that many are happy to buy. 

Real estate is the big beneficiary. Why has Singapore property market gone from S$1,000 psf to S$1,500 and S$2,000-S$2,500 psf? Did Singapore really more than double in attractiveness? Did the property developers suddenly make much higher quality condominiums with a smaller balcony and better interior? Did our government really make Singapore super attractive in with lots of greenery and better MRT, better healthcare in the last ten years? I think it is just global negative interest rate in action. Global property prices in global cities have been going up. Asian cities have reached 1+% rental yield. This means that it will take almost 100 years to recoup your capital if you don't sell. Singapore leasehold properties are only for 99 years.

Private equity markets gave us another interesting story. With negative yields, investors started hunting for returns everywhere. They found hundreds of unicorns - startups and disruptive technologies that promised to change the future. Alas, most aren't real. We saw how WeWork blew up. Uber and Lyft also saw the share prices plunged. Investors were willing to put a lot of money into dreams about rainbows and mythical horses because there was simply too much money around and nowhere to invest to earn good returns.

To sum it up, we are now in unchartered territories and we must proceed in prudence to find the optimal way forward. First, own at least one property because we don't want to get caught short. Property prices are not going to fall as long as negative interest rates continue to dominate the bond markets. Next: focus on equities because it would continue to grow with bonds becoming less attractive and private equity being too cowboy (re: Theranos). We also need to tweak how we use valuations. We can no longer work with 15-20x PE in the new negative yield regime. Maybe we have to buy good companies at 30x PE. The new cheap could be 20x PE. Hope this helps!

Huat Ah!

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