What Is Inverted Finance & The Time Value Of $?
If I asked you for a $100 and only repaid you $95, would you transact with me? Of course not, as I suspect that most monkeys here have gone through at least one course in corporate finance. However, some people would. I present to you a case in real finance, the German 2-year, the Swiss 5-year, and even back in 2009, the U.S. 3-month bonds all traded with a negative rate of return...and investors were buying them! But why would any rational person invest in a negative return? Two concepts: yield-price relationship and risk premium, read more to find out how they work…
One of money’s characteristics is a store of value which means that one can forgo spending today and expect a stable value in future expenditures. When you invest your money there is an opportunity cost to that decision and as compensation, an interest rate is paid in addition to the principle reflecting the time-value of the invested money you could have spent otherwise. When calculating a return for this time-value, a positive interest rate is always used as its assumed investors are rational and wouldn’t make a certain losing investment. For example,
...the future value of a $1000 U.S. 3-month bond yielding 1% with a coupon of $10 is $1060.60 which is greater than its par value, a rational decision. But, if we invested at -1%, the future value then becomes $940.60 which is less than par, a certain loss."
Yet, European investors were choosing the latter option, so how does this happen?
There is an inverse relationship where rising demand increases the bid price of bonds as the supply of loanable funds from investors shifts rightward thus, reducing interest rates. Simply put, by bidding up the demand for German bunds it drives interest rates down. The result, is shown as a shift in the German yield curve in July (green) from the month prior (yellow). Timeliness is not of importance but rather the information, note how the curve has shifted downward and look at the shorter-term maturities.
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Here’s another graph, specifically the 2-year bund and you can clearly see the negative interest rates plotted by James Mackintosh of the Financial Times.
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Why would a rational person invest with a negative return?
The risk-premium, or rate of return in excess of a riskless return, can help explain this behavior. A bottoming-out of the yield for short-term maturities indicates that capital outflows are leaving longer-term ones and going into the likes of the 2-year which has caused a distortion in the yield curve. This is indicative of excessive demand for very liquid, risk-adverse assets and a flight from the longer maturities whose risk-premiums are inadequate to compensate for the time-value of money and the probability of loss.
Primarily, I suspect that the German bunds are perceived as a safe haven, like the Franc in the currency market. Secondarily, there has been a absence of investment opportunities due to the austerity measures and lackluster economic growth. Lastly, there is an ebb and flow of the probability of denomination risk or the possibility of an all out exit among the PIIGS.
That’s my perspective but voice your opinion and let us know…what’s your analysis on these negative interest rates and what do you think it signals?
Nice article
All of this assumes that markets are not manipulated to the point of incoherence. The ECB, BoJ, the Fed, and others are major purchasers of sovereign liabilities. They don't care about yield or profit (how else does Greece or Spain even have access to capital markets). Their actions and stated policies instigate purchases of private speculators looking to flip to the central banks, which would be a certain profit, not loss. So even if bond yields are negative doesn't mean that a central bank (or other private speculators) won't purchase the bond at yet a higher price. This phenomenon is known as a bubble. This is an example of central bank-sponsored "greater fool" syndrome- where you are a fool for not front-running.
"Primarily, I suspect that the German bunds are perceived as a safe haven, like the Franc in the currency market. Secondarily, there has been a absence of investment opportunities due to the austerity measures and lackluster economic growth. Lastly, there is an ebb and flow of the probability of denomination risk or the possibility of an all out exit among the PIIGS."
Yes--seems as if it's a clear flight to quality, like US investors and Treasuries. I also think your last point is one of the reasons people are flocking to the German bunds, in your first point.
The Fed and ECB's ZIRP have given investors no choice but to increase their risk appetite. The monetization of debt has driven borrowing costs so low that Treasury (or just "safe haven") returns are being outpaced by inflation. To earn any reasonable return you have to take riskier ventures--namely equities, in the case of the US and post-QE1 & 2 markets. It seems as if they're looking to stimulate the economy in that way.
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I believe that this is only part of the puzzle.
Well, to start with, buying a bond at a negative yield does not mean that you earn less than inflation, as it has been suggested in an earlier comment. The Bund's is a negative yield in nominal, not real terms. It means you pay more than par, say 1.001 euro for every 1 euro you receive at maturity.
I believe this to be basically a supply-demand effect. It is a direct consequence of flight-to-quality, because the German treasury isn't issuing at the same pace as the market is willing to absorb. On the other hand, it makes little sense to imagine people are buying it in order to ride capital appreciation (i.e. buy it at -0.05% to sell it at -0.10%), for this is highly unlikely and irrational, and since price movements in short bonds are very tight, you would need to lever shit up the roof in order to make any decent money from it. And that, of course, would expose your estate to the risk of whoever runs the show supplying the market with a bunch of Bunds, bringing the rate back to +0.10ish and taking you out of business. You're better off just buying puts, shorting the damn market or buying a fuckton of vol if you truly believe shit will hit the fan this bad.
The fact is that a negative nominal yield is a theoretically irrational price, but behavioral finance shows that those can occur in the absence of perfect arbitrage possibilities. This means that if in theory you could borrow a zero bond at a premium, sell it short and repay $1 to the original creditor that expects to get that $1 at maturity, for a 0.01 or whatever sure profit. However, not even mentioning that the arbitrageur credit risk is not zero (unless it is Germany, in which case it would be just... issuing bonds!), in the real world, stressful moments prevent arbitrage from being engendered, and in reality you won't find Bunds available for borrowing at a negative cost, even if that's what they're yielding to the long natural holder. In moments like this, if there is any borrow volume, it will be at a high cost (a lot of collateral obligations to fulfill, everyone bracing themselves, and little eligible collateral in the street), ruining the expected value of the arbitrage.
Another arbitrage opportunity (at least relative to the whole flushing money down the toilet status quo) would be to just say well fuck you all, I will hold cash. But then again, there is credit/counterparty risk for holding any cash beyond the individual investor government guarantee in a financial institution. That is also true for joints such as a corporate bank, a private bank, a prime brokerage account, etc. At the limit, you could actually call the bank and arrange for physical withdrawal, but physical storage + insurance costs would probably outweigh the negative rate you now face at the market.
There are many other strategies to replicate a risk-free security, such as (1) long index component stocks short stock index, (2) long asset, long put, short call at same strikes, (3) similar duration corporates and non-German sovereigns (hedged through CDS and NDFs, respectively). All of those have a bit of basis, pricing and execution risk, which most certainly exceed whatever peanut negative rate you are currently "paying" for the privilege of holding the Bunds in your portfolio.
Rates in the US a few years back were actually more negative than this (and with 3mo t-bills, compounding the problem). This indicates that the whole flight to quality (even from banks) could be the explanation for Germany's problem right now. IMO, rates can get as negative as much as agents can disregard banks as a faithful depositary of their $ (with a natural lower arbitrage boundary: cost of physical withdrawal + transportation + storage + insurance of the physical monetary medium).
Thank you everyone for your insightfull comments, they're great! It's good to read some differentiated views on this situation, especially for the younger monkey's.
Excellent commentary! I look forward to your input in my future articles.
For those of you unfamiliar with inflation expectations, look at TIPS yields relative to nominal Trasuries. The 5 year Treasury is yielding about 70 bps. A 5 year TIPs auction just took place with a yield of about negative 1 1/4%. This means the US bond market is expecting inflation to be about 2% over the next 5 years because people can lock-in a real yield of -1.25% by buying TIPs or can buy a 5 year Treasury yielding about 70 bps and have a known nominal yield, but an unknown real yield. http://www.businessweek.com/news/2012-08-23/five-year-tips-sale-draws-r…
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