About six weeks ago, a Scandinavian bank management team visited our office. The country they operate in have had negative yields for some time and during our meeting the team mentioned that the bank had lent out its first negative interest rate mortgage with a rate of -0.01%. This made me think about how wonky the world is today. Governments can borrow money at negative yields, which in essence means someone gives the government money today and pays them for the privilege! There are currently over $2 trillion worth of bonds in Europe with negative yields (30% of total), and $3 trillion globally. In fact, the only country in Europe with 100% of its bonds above a 1% yield is Greece – what a difference a few years and a few trillion of QE makes.
Logically the concept of paying to lend money makes no sense. Of course there are costs in holding cash and there are examples of institutions that have no choice (e.g. pension funds, the ECB, etc.). At Cambridge we are naturally risk-adverse. A key aspect of our philosophy is understanding risk and ensuring the rewards for taking on risk are justified when making an investment. How do you make this calculation when your base case reward is a loss? Of course the answer is you must be speculating, but that isn’t what we do at Cambridge.
This massive decline in bond yields isn’t bad for everyone. Here is a table showing the refinancing opportunities for Effiage, a company we have been researching:
Source: Eiffage Q4 results presentation
Imagine being able to refinance your 7.5% bonds at 0.01%! For the right businesses in the Eurozone, with the right assets and stable cash flows, this refinancing wave could be a boon for equity holders.
Most agree that government bonds offer unattractive risk-reward but let’s put this into some context:
Source: Bloomberg data
We can see that the implied earnings multiple (the inverse of the yield) for the USD 10-year bond is off the charts. But remember, while at least in the short run, the stock market is a voting machine and the Federal Reserve governors – who happen to be appointed – get to manage interest rates.
Low bond yields are increasing asset values across markets, which is nice for those who had capital invested. But be careful not to extrapolate recent results into the future. Remember, the yield-to-maturity is what you get if you hold a bond until redemption.
But isn’t this robbing the future to pay for the sins of the past? If you have long term retirement goals, “risk-free” assets no longer offer reasonable returns. You have a few choices to make: you can reduce your expectations, save more, or take on more risk. I think any of these options reduce future economic growth potential, with the first two choices resulting in a smoother ride than the third!
No wonder a lot of people are choosing not to save…
I was visiting my bank the other day and was trying to explaining how I would like to teach my children about the benefits of savings. The representative suggested opening an account for them would not be a good idea since after fees they would only see their balance shrinking over time. This was a very depressing outcome for a parent wanting to instill certain values in my children.
And here is the rub: many of the most successful investors of the last half century have touted the beauty of compounding. How do I teach my children about compounding when depositing money in a bank will see their wealth shrink over time?