Investors chasing positive returns in European government bonds are fast running out of road.
Only six weeks into the European Central Bank’s EUR1 trillion ($1.07 billion)-plus bond-buying program, over half of the eurozone government debt market now offers investors a negative yield.
Given that yields fall as prices rise, this means European fixed-income markets have never looked so expensive.
“These sorts of yield levels are a big concern,” said Andrew Bosomworth, head of Pimco portfolio management in Germany, which oversees $1.6 trillion in assets, with investors potentially looking to riskier assets to generate returns.
Investors buying negative-yielding bonds can only make money if inflation consistently remains below zero, or someone else agrees to buy the bond off them at an even higher price.
The latest ECB survey of professional forecasters indicated eurozone inflation should rebound to 1.2% next year. This is still some way off the ECB’s medium-term target of close to, but below, 2%, but far above the minus 0.1% inflation rate in March.
Relying solely on price rises to make money is a risky game. This kind of speculation is more closely associated with stock markets than the staid world of bond investors, who traditionally make money by collecting regular coupon payments.
Virtually no eurozone government bonds offered a negative yield a year ago. This began to change when the ECB cut its deposit rate into negative territory last June and expectations of a quantitative easing program mounted.
By last September, one fifth of the EUR5 trillion eurozone government bond market had a negative yield, according to Bank of America Merrill Lynch. That number crept up to EUR2 trillion by late February after the ECB announced QE on January 22.
The launch of that program on March 9 merely accelerated the trend. Now, EUR2.8 trillion of eurozone debt offers a negative yield, according to BAML.
“The risk is the pool of negative-yielding bonds keeps going up,” said Barnaby Martin, a credit strategist at BAML.
Mr. Martin noted investors jittery over the prospect of Greece defaulting should continue to flock to the relative safety of German government bonds. That combined with ECB President Mario Draghi saying that the QE program wouldn’t be wound down before its slated finish of September 2016 should mean the pile of negative-yielding debt continues to grow.
Pimco’s Mr. Bosomworth said he has been worried about bubbles forming across asset classes: in stocks, bonds, and real estate. But, with the ECB’s quantitative easing program only just ramping up, he isn’t anticipating those bubbles bursting just yet.
“Those asset prices could continue to inflate,” he said.
Many investors are aware of the perils of buying negative-yielding debt, but can do little about it. Regulation forces financial firms to hold large swaths of government debt. This, combined with the ECB’s bond-buying program, is pushing yields ever lower.
“There is a complete disconnect with economic fundamentals and nominal GDP growth,” said Franck Dixmier, chief investment officer at Allianz Global Investors in Paris, which oversees EUR197 billion of fixed-income assets.
Fears over a scarcity of German bonds, in particular, have led to 70% of that EUR1.1 trillion market trading with negative yields, according to Tradeweb.
Mr. Bosomworth predicts it is only a matter of time before the 10-year German government bond yield, the most important reference point for investors in Europe, dips below zero. It is currently 0.16% compared with 0.40% before the ECB started buying on March 9.
Despite these worries, some investors see this as a great opportunity. Bill Gross, the former Pimco chief who last year jumped ship to Janus Capital, said yesterday that German 10-year bonds are the “short of a lifetime”.
Tony Lanning, a multiasset fund manager at J.P. Morgan Asset Management, which oversees $1.7 trillion in assets, noted that people were saying the same thing when German 10-year bond yields were 2%.
Given the investment backdrop, Mr. Lanning favors stocks in general. Within fixed income he likes high-yield bonds where the returns on offer look more attractive. But he said it is still a good idea to have some high-rated government bonds, which will perform well if economic growth is sluggish.
“These depressed and, in some cases, negative yields clearly aren’t a good long-term investment. But if we still have QE, it’s right to have a bit [of exposure],” said Mr. Lanning.