The T Report: Negative Yields. What They Mean and How to Trade Them.

Negative Yields

So Germany issued some Bundesschatzanweisungen (affectionately known as “Schatz”) at a negative yield. So 2 year bonds, with no coupon, were issued above par creating a negative yield, and the demand was strong.

What does this mean? Why lend money to Germany for 2 years and receive no interest and get let money back than you gave today? And it cannot just be retail investors. This has to include bond managers and even hedge funds who charge a fee to earn zero. So they must have a play in mind. There has to be a reason they are buying bonds at zero and negative yields.

• Squeezenshorts? It cannot just be a short squeeze. While many investors have been short German debt as a bet that it will cost Germany a lot of money to bail out Europe, there are just too many investors who view it as a safe haven. So it cannot be short covering.
  
• Deflation? Could it be that investors are so worried about deflation that they will accept a negative return from a safe counterparty? That could play a part, but there are better ways to express that view. Also many of the most likely “deflationary economic collapse” scenarios center around Europe, so why invest in a currency that would probably get hurt?
  
• Deutschemarks? Is this really a bet on currency break-up? Are investors expecting that either weak countries will be kicked out of the Euro, providing for currency appreciation? If so, why not just buy the Euro outright? Are they hoping to get converted to Deutschemarks? If you think Germany will go for Deutschemarks then you could be buying German bonds at these yields in the hope of getting paid back in a strong currency? That makes some sense as your downside by lending to Germany is limited, with some potential upside, but a Euro break-up might not result in bond conversion.
  

So I don’t have a great answer of why this is occurring. The only one that makes sense to me is that it is a play on reversion to old currencies. The idea that negative yields are a result of investors hoping to get a new currency than anything else seems to make the most sense. If the Euro stays together, Germany will be using a lot of its funding power (indirectly through guarantees of EFSF and ESM), so the yields should rise. If a deflationary spiral is about to start in Europe, holding German bonds will be good, but there is no significant upside from that alone, and that scenario doesn’t seem good for the Euro. Treasuries would likely be a better way to play that. So it is hope for currency reversion that is playing a major role in this zero yield. That explains better why Germany, Finland, the Netherlands and France trade so well. They trade at lower yields than treasuries and their central bank hasn’t promised 0% rates for eternity, unlike ours.

Other bits of info fit the currency strategy, since the record low yields are being set in a time of “risk on” or at least “risk meh”. Stocks are well off their lows and continue to perform solidly. Corporate credit is doing well. MAIN is 2 bps tighter on the day and IG is opening a touch tighter as well. If the end of the world was nigh, then we should be seeing significant spread widening. So it really does look like this is a currency play.

Does the “Currency” Trade Make Sense?

That is the big question. What would happen to the Euro?

• Kick out the weak and have a strong Euro. This would seem to be the easiest way. Let the weak countries leave and have a remaining bloc of strong Euro countries. Buying German bonds at negative yields could work as they wouldn’t be issuing debt to support the weak countries (which would now have their old currencies). The Euro, or what’s left of it could easily appreciate making the bond purchase worth it. For an investor that needs some exposure to the Euro, this may be a “safer” investment than Spanish bonds.
  
• Strong Countries leave and there is a Weak Euro. I don’t see this scenario being likely. Once some big countries leave, there will be no Euro. Spain and Italy don’t benefit enough from a common currency to stick around once Germany and France leave. It just doesn’t seem possible for a Germany to leave and still have a Euro. Finland is a different story. Of all the countries Finland is the only that could leave and have a strong currency and credit profile while leaving the Euro intact. Maybe the Netherlands or Austria or Belgium could, but I think they all benefit too much from the Euro that their economies might do worse if they left by themselves. So Finnish bonds at zero may look cheap to Germany as they have a possible exit that Germany doesn’t.
  
• Full Reversion. Since I believe that if Germany leaves, everyone will leave, then there would be no Euro. Maybe that can be done quickly, but Europe doesn’t like to do anything quickly. I think we would have to see a transition period. The transition into the Euro was managed over a period of years. Bonds were issued in Euros before Euros were used as local currency. I could see something like that happening here, in which case 2 year German bonds might not benefit from conversion. Those might live out their life in Euros, and I can’t see the Euro ending its life strongly relative to other currencies. A long transition to old currencies would likely be the worst outcome.
  

I think Finland is a better way to play the zero yield game than Germany. They have an exit strategy that would be good for the bonds that Germany doesn’t have. They have also been more careful on their bailouts (demanding collateral) so won’t be hurt as bad from a credit perspective if Europe is saved.

I think EFSF bonds are a bad way to play this trade. If currency break-up becomes the “solution” to the Euro, I don’t see how EFSF bonds do well. The structure of EFSF is convoluted and has risks of not working well for what it was intended, let alone how it will work if the Euro fails. What currency will these bonds get changed to? Will the debt be switched to the currencies of the best guarantors, or to the currencies of the countries that received the funds? I have no idea, but I think there would be so much headline risk around these bonds as currency break-up is contemplated that they are a better short than long here.

My view remains that incremental steps are occurring and working and that Europe will remain together, in which case Spain and Italy look cheap, and Germany and other look very rich. Under this scenario, the EFSF bonds would also do poorly as we should see yields across the core rise as they use lending capacity to save Spain and Italy.

Corporate Credit Remains Strong

I’ve already mentioned that the CDS indices are doing well. The high yield bond market continues to do well and HYG and JNK are back near their highs for the year and continue to drip out a steady dividend and drip in more flows.

Retail continues to shift money to fixed income and I continue to believe this shift is warranted as the asset class was underinvested. We created too much of an “equity” culture and fixed income was just a “throwaway” in terms of time and effort. The return profile of fixed income is useful and asset classes like high yield and leveraged loans have been underinvested. The current price appreciation in treasuries may not last, but fixed income should continue to provide opportunities and timing them, while not as important as timing in equities, shouldn’t be ignored.

In Emerging markets, the local currency bonds (LEMB) has lagged dollar denominated bonds (EMB), but both have done well. Again, this is unlikely to have occurred if the move to zero and negative yields in Germany was purely a fear trade. A global deflationary meltdown tends to, umm, not work so well for EM debt.

It remains a tricky market. Many are saying we are near the top and due for a correction. I can see the argument, but as far as I can tell, it has been a tough year for many credit hedge funds. The best ones are doing well. They have timed the market well, and in many cases, were involved in the whale trade. Those that haven’t done well need to figure out how to make 6% or more in the next 6 months, and being short sounds sexy, but carry is tempting, especially in a world where central bankers seem to thwart every decent downward move. For all the problems in the world and our own economy, the window where you could have bought credit products and be down money is very narrow. At this point there isn’t really a day you could have bought HYG and had negative returns. On IG, there are still a few days all centered around the March lows that are money losing trades, but again, the resilience is pretty surprising.

I continue to like high beta high yield CDS from the long credit standpoint. These names have remained stubbornly high and relentlessly cheap to cash, but that technical seems to be dissipating and if we get another round of “reach for yield” the areas that have been ignored, should outperform as the liquid bonds have been thoroughly picked over.