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Date: September 17, 2019
Category: Credit

Global Capital’s Flight to Safety: Where Should it Land?

Everyone has their security blanket. For some, it’s the comfort of home. For others, it’s a favorite keepsake. In the investment world, it’s government debt, believed to be a tried-and-true stabilizer in times of volatility. Negative yields and shockingly low rates elsewhere in the world have sent global investors looking for yield into the “safety” of the U.S. bond market. Yet, as this dynamic accelerates, you should take a closer look at global credit markets to determine how best to find the risk-adjusted yield you need.

The Euro story

Two decades ago, well over half of the global bond market boasted yields of at least five percent, according to ICE Data Indices. The good ole days for income investors! A post-recession splurge of bond buying and rate cuts sliced that number to below 16 percent a decade ago, but fast forward to present day … and it’s just three percent.1

Not even accounting for European central bank intervention, global investors are staring at shelves of fixed-income instruments that carry no real yield. We’ve waded even further into the deep end of negative-yielding sovereign debt, now hitting close to $16 trillion, up from $5.7 trillion last October.2

Germany is one of the starkest examples with yields all along the yield curve trading below zero. On August 20, buyers were paying the equivalent of $195.87 for every $100 in 20-year bunds, all for the “attractive” technical yield of -0.386 percent.3 Denmark, Netherlands, and Finland are three other Eurozone markets offering coupons with negative yields across maturities. Beyond the Eurozone, Japan still holds the most negative-yielding sovereign debt, amassing nearly $7 trillion as of August 13, more than the next six countries COMBINED.

A negative yield is symbolic of how much above par investors are willing to pay for these bonds – not that the coupon is below zero. These investors are making a bet that rates will stay muted as bond prices rise. However, if rates were to rise even a little, say two percent on the resolution of the U.S.-China trade war, a new study from Bianco Research states that Swiss bonds would lose roughly 50 percent of value to current bondholders.3

Remember, these bonds are only required to pay off at par when they mature. Yet investors have been forced to pivot to riskier assets beyond sovereign debt, that if held to maturity, would pay off subzero yields. Negative-yielding global corporate debt, while relatively new, has risen from just $20 billion in January to about $1.2 trillion now.4

So, with global income options bleak across many risk assets, the search for positive late-cycle returns has turned to the United States.

How does the story end for the U.S. bond market?

This is objectively a European phenomenon. U.S. bonds account for just under half of the $55 trillion global investment grade bond market – but they pay out 88 percent of the yield!1

Negative yields are also causing a distortion in the pricing of global duration and credit risks. If 10-year Treasury yields continue to plummet, it may not make long-term sense to hang a risk-off strategy on Treasury appreciation-driven returns. With U.S. corporate bond yields falling as well, investors must determine the best avenue to drive late-cycle returns. While global capital will likely continue to flood the last real yield market until a recession occurs, where’s the best place to invest?

Pension funds and insurance companies staring at this problem are balking at a move further up in maturity, and are instead moving further up the credit curve to avoid negative or historically low yields. While it’s better than zero percent abroad, U.S. Treasury yields have fallen over 100 basis points and U.S. corporate bond yields have dropped nearly as much in just over a year. Meanwhile, senior loan yield-to-maturity is actually 97 basis points higher than a year ago. For those investors concerned about credit quality and potential late-cycle defaults, here’s two data points that may calm any jitters. J.P. Morgan projects corporate credit default rates to remain below historical averages through at least 2021, and nonfinancial business debt was at $6.4 trillion at the end of Q1 2019, only 33.7 percent as a portion of its equity, down from the recession peak of 69 percent in early 2009.

With the economy still expanding, leverage manageable, and credit quality sound, corporate credit investments may offer higher risk-adjusted yields at this point in the cycle. For those moving money from overseas, a ticket into middle-market loans and high-yield bonds may be attractive.

1 Financial Times. Negative yields force investors to plunge into riskier debt. 8/15/19.

2 Bloomberg. As Negative-yielding Debt Balloons, This is How to Track It. 8/14/19.

3 CNBC. Surge in corporate debt with negative yields poses risk ‘unlike anything’ investors have ever seen. 8/21/19.
 
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