At the beginning of August, 30-year German government bonds traded at negative yield levels for the first time ever. Central bankers and investors must be wondering what’s next.
During the last 25 years, yields on 30-year German government bonds have fallen from around 8% to 0%; since the financial crisis of 2008 alone, yields have fallen by 5 percentage points.
Figure 1 Germany 30-year bond yield 1994 – 2019 (source: Investing.com)
Now that even 30-year German government bonds are trading with negative yields, financial markets are even further into unchartered territory. It is simply extraordinary to think that investors lending today to the German Government for 30 years will receive less money on repayment than they originally lent.
While this is a fact in nominal terms, in real terms, i.e. taking inflation into account, the situation is even worse for investors. The average inflation rate over the last 10 years in Germany has been 1.3% per annum. Compounding this average over a 30-year period would result in an investor recouping only slightly more than 50% of the real value of the original investment in real terms at repayment.
Many bond investors will look back over the last 12 months and justifiably conclude that it has been a very good period for investment due to the large capital gains that have ensued. However, that development has effectively served to cannibalise bond investors’ returns for the next 30 years.
So, how should bond investors position themselves going forward?
Unfortunately, there is no easy answer to that question. To do so requires addressing two other questions: who, apart from central banks and investors with a benchmark in government bonds, would invest in bonds with negative yields; and, ignoring current interest-rate levels for a moment, is capital in the economy allocated in an optimal way?
Under “normal” circumstances, central banks would lower interest rates so that lending would become cheaper and thus encourage more corporate investment in research and development, or in real assets such as plant and machinery. Since the financial crisis of 2008, this formula seems to have disintegrated. While central banks have cushioned the effects on the financial system by providing it with unprecedented liquidity courtesy of a highly accommodative monetary policy stance, that liquidity has been largely used to shore up shaky balance sheets or invested into assets such as bonds, equities or real estate – little of it has found its way into the real economy, where it is most needed (e.g. small and medium-sized companies).
Such behaviour by risk-shy banks has created two very different economic environments: a “liquid assets“ sphere reflecting the currently low level of interest rates and abundant liquidity; and a “real economy” sphere wherein interest rates are effectively at the levels of the mid-1990s.
A further important consideration is how liquid these “liquid assets” might prove in another downturn in financial markets. The Governor of Bank of England, Mark Carney, addressed the issue of investing in liquid funds such as UCITS in his recent testimony to the UK parliament. “These funds are built on a lie,” said Carney, “which is that you can have daily liquidity,” for assets that are fundamentally illiquid; this, he continued “leads to an expectation for individuals that it’s not that different from having money in a bank”.
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