Why its brave to bet against Bunds

05/08/2019

During my 25 years in bond markets, there’s always been one potentially lethal trade for bond investors.

The “widow-maker” baton has changed hands through the years, but in each case investors have made very costly bets against bond prices continuing to rise. Today, it is German government bonds that pose this threat.

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Investor demand for German bunds, being widely seen as the ultimate ‘safe’ investment, has continued to push their prices up and up. This has pulled their yield – prospective annual investment returns as a percentage of the price paid – down to record lows.

Yields on 10-year bunds, maturing in 2029, have fallen well into negative territory and stood at roughly -0.3% in early July 2019. At this yield, investors are effectively paying £3 a year for each £1,000 they are lending to the German government. Remember that past performance is no guide to how any asset will perform in the future.

Much as these negative yields might instinctively defy logic, many investors expect bund yields to fall even further. Madness, surely?

Why does anyone buy negative yielding bonds?

Well, perhaps. To understand the logic behind these forecasts, it can be worth refamiliarising ourselves with why investors would even consider buying negative-yielding bonds in the first place.

There are fundamentally four reasons. The first is the perceived safety of bunds, in that it is unforeseeable that the German government will default on its bond repayments. The near certainty that investors will get their money back – albeit less than they initially paid – comes at a price.

The second reason is the chance of selling them on for a profit. While you would make a loss by holding the bunds to maturity, if bond yields fall in the meantime, you could sell them for a higher price than you paid.

Thirdly, negative yielding bonds could look appealing if you expect to receive a lower negative interest rate on bank deposits – in other words, if you are effectively charged for keeping your savings in the bank.

Finally, the possibility of falling prices, or deflation, can also make negative yielding bunds attractive. If the rate of deflation exceeds the negative yield on the bonds, investment returns will effectively be positive.

Why might bund yields fall further?

All of these factors can be seen at work in the case of German government bonds today.

The threat of deflation lingers in the eurozone, where consumer prices continue to rise at a rate of barely more than 1% a year – below the European Central Bank’s (ECB) target of “below, but close to 2%”.

With economic growth remaining weak across the eurozone, the ECB is widely expected to support the economy with a cut in interest rates and the resumption of quantitate easing (QE). Under QE, the ECB buys up eurozone government bonds, in proportional amounts, to encourage investment elsewhere in the economy and thereby support growth.

Since ECB bond buying bolsters demand for government bonds, therefore pushing up their prices, QE would be expected to further reduce government bond yields. For bunds, I would expect this effect to be greatly magnified by a shortage of supply – after all, the German government is running a budget surplus, and bund issuance is exceptionally low.

One investment bank has forecast that, in this environment, the yields on 10-year bunds could fall to as much as -2%. This might sound extreme, and it would take aggressive monetary policy from the ECB for this to become a remote possibility.

Yet even if bund yields do not tumble this far, but instead fall modestly further into negative territory, it could be costly to bet against the bunds’ defiance of gravity.

History tells us that investors should be wary of putting the house against further falls in bund yields. Economist John Maynard Keynes was not wrong when he famously warned that “the markets can remain illogical for longer than you can remain solvent”.

The views expressed here should not be taken as a recommendation, advice or forecast.

The value and income from any fund's assets will go down as well as up. This will cause the value of your investment to fall as well as rise. There is no guarantee that any fund will achieve its objective and you may get back less than you originally invested.