The Incredible Upside-Down Fixed Income Market: Negative ...

The Incredible Upside-Down Fixed Income Market: Negative Interest Rates and Their ImplicationsThis work will appear as a CFA Institute Research Foundation monograph later in 2021, at https://www.cfainstitute.org/en/research/foundation/publications. I’d like to thank the Research Foundation for its support.

Prepared forQ Group Monthly EventJune 14, 2021Vineer Bhansali, Ph.D.CIO, LongTail Alpha, [email protected]

Expect the Unexpected for Sustained Portfolio Performance

This material contains the current opinions of Dr. Bhansali and such opinions are subject to change without notice. This material has been distributed forinformational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investmentproduct. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproducedin any form, or referred to in any other publication, without express written permission. LongTail Alpha, LLC, 500 Newport Center Drive, Suite 820, Newport Beach,CA 92660. ©2019, LongTail Alpha, LLC.

FOR EDUCATIONAL USE ONLY

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What Is Going On In The Bond Markets?

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Over 20% of the total bond market, or almost $15 trillion of bonds is trading at negative yields, and will lose value if held to maturity.

Source: Bloomberg, LongTail Alpha


0%

5%

10%

15%

20%

25%

30%

35%

Negatively Yielding Bonds as Fraction of Total Bonds Outstanding in Global Aggregate

Negative Yields Around The World

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Source: Bloomberg, LongTail Alpha as of June10, 2021

Core European Rates and Yields

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“It seems fair to say, however, that the free market long-term rates of interest for any industrial nation, properly charted, provide a sort of fever chart of the economic and political health of that nation.” —Sidney Homer, A History of Interest


Increasing Duration of Negatively Yielding Bond Universe

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Source: Bloomberg, Bianco Research, LongTail Alpha

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Negatively Yielding Bond Statistics

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Total Returns of Bond Markets Have Been High Due to Rising Prices of All Bonds

Uncharted Territory Where Even Economists Disagree

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The idea of negative interest rates may strike some people as absurd, the concoction of some impractical theorist. Perhaps it is. But remember this: Early mathematicians thought that the idea of negative numbers was absurd. Today, these numbers are commonplace. Even children can be taught that some problems (such as 2x + 6 = 0) have no solution unless you are ready to invoke negative numbers. —Greg Mankiw, “It May Be Time for the Fed to Go Negative,” New York Times

“there’s something vaguely troubling when the

unthinkable becomes routine” BIS 2019



For starters, just like cuts in the good old days of positive interest rates, negative rates would lift many firms, states, and cities from default. If done correctly—and recent empirical evidence increasingly supports this—negative rates would operate similarly to normal monetary policy, boosting aggregate demand and raising employment. Rogoff 2020

Pricing Basics

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𝑃𝑉 = 𝑐 𝑒−𝑟𝑇

• When 𝑟 < 0, the PV grows with time• Current price is higher than future price• So the bond “time decays”• This looks like an option – it is an option• This calculus turns everything upside down

• Shorting earns a time premium


“The God Particle” of Finance: Negative Yield, Zero-Coupon German Bund of 2050

• Maturity: 31 Years

• Coupon: 0%

• Redemption Price: 100

• Issuance Price: 103.61

• Issuance Yield: -0.11%

• Guaranteed Loss If Held To Maturity: 3.61

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• The duration of a zero coupon bond is roughly equal to its maturity.• So this bond’s percentage price movement is ~31% for 1% change in

yields! • The price premium roughly equals duration (31) times the yield (~-

0.12) to equal 3.6 points.• We can think of this bond as an INSURANCE POLICY against

“deflationary forces”, which could be used to justify its price above par.

Source: Bloomberg, LongTail AlphaFOR EDUCATIONAL USE ONLY

Rarely in human history have humans willingly accepted future value that is less than present value!

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Source: Bloomberg, LongTail Alpha, Public Domain Images

The “Semper Augustus” Of Today’s Finance: Zero-Coupon Austrian Bund Maturing in 2120 (99 years), with current

yield of 1.04% per year.

“Few people ever actually saw a Semper Augustus flower. The man who held a near monopoly on the small supply-refused to sell his bulbs, which drove up the price. In 1638, one was advertised for 13,000 florins, the price of a nice house. That was the year the market for tulips in the Netherlands crashed.” Source: https://www.atlasobscura.com/articles/the-most-beautiful-tulip-in-history-cost-as-much-as-a-house


Maturity: 99 yearsCoupon: 0.85%Yield: 1.04%Low Yield (Dec. 2020): 0.38%Modified Duration: 64Convexity: 54

https://www.atlasobscura.com/articles/the-most-beautiful-tulip-in-history-cost-as-much-as-a-house

Even Some Non-AAA Corporate Bonds Have Negative Yields!

Paying To Lend To Someone Who Can Unilaterally Choose To Not Pay You Back

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Why Might This Be Happening?

• Central banks in Japan and Europe are not able to generate persistent inflation which is their main objective• Deposit rates are well below zero in most of Europe and Japan

• In Japan, more and more debt is being issued to stimulate an aging economy;

• In Europe, there is no common fiscal policy, so monetary policy is the main way to transfer savings from Northern European states to the Southern countries

• Central Banks have continued to print money and promised to print money as far as the eye can see via “forward guidance” and “whatever it takes”.

• Global economy post crisis has become dependent on low rates, so any rise in rates is met with an equity market tantrum which Central Banks implicitly are worried about (“financial instability”)

• Or • Alternative Hypothesis: Market could be correctly anticipating

deflation, default and geopolitical troubles that makes return of capital more important than return on capital

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Convergence of Monetary and Fiscal Policy

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From the point of view of sequences of government IOUs called bonds and money, institutional arrangements that delegate decisions about bonds and money to people who work in different agencies are details. Central bank independence is a convention or a fiction. —Marco Bassetto and Thomas Sargent, “Shotgun Wedding: Fiscal and Monetary Policy”


The Mechanical Economy According to Central Banks

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Source: ECB

The Four Largest Central Banks Have Each Exploded Their Balance Sheets

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Source: Yardeni Research as of 6/7/2021

Total Balance Sheet of Central Banks Is Now Almost $30 Trillion

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Source: Yardeni Research as of 6/7/2021

Who Buys Negatively Yielding Bonds

• Central Banks: Using monetary tools for fiscal ends

• Passive Agents: Those who must due to prospectus, i.e. index bond funds

• Risk Managers: Those who must due to risk management reasons, i.e. pension funds hedging liabilities, or “convexity hedgers”

• Speculators: Those who are looking to buy them now to sell them to someone else at a higher price (“greater fool theory”)

• “Quants”: Those who look at prices, but not yields, e.g. trend followers, systematic traders

• Arbitrageurs: Those who are looking to arbitrage cross-currency interest rate differentials

• Liquidity Seekers: Those who can use the high priced, negatively yielding bonds for repo

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Everyone!

BNDX: Global Bond Index Fund ETF Growth

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Indicated Yield: 1.10%Approximate Yield From Currency Hedging: 0.50%


To compute the approximate yield from currency hedging, we assumed that the currency risk of each foreign bond was hedged out using a one month currency forward contract.

0

5000

10000

15000

20000

25000

30000

35000

40000

45000

BNDX Bond ETF Market Cap in Millions

Trading Sardines: How Currency Hedging Turns Positive Into Negative and Negative Into Positive

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(1.50)

(1.00)

(0.50)

-

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

Dollar Investor Euro Investor Yen Investor

Currency Hedged 10 Year Yields

US Germany France Italy UK Japan Australia Canada

FX Hedged Yields US Germany France Italy UK Japan Australia Canada

Dollar Investor 1.72 2.08 2.39 3.56 1.93 2.28 2.19 1.86

Euro Investor (0.82) (0.52) (0.22) 0.92 (0.64) (0.33) (0.39) (0.70)

Yen Investor (0.70) (0.40) (0.10) 1.05 (0.52) (0.21) (0.27) (0.58)

Source: Bloomberg, LongTail Alpha as of August 2019


Example Holding: BNDX holds this German 10 year zero coupon bund issued at a 3.61 point premium and negative

yield of -0.11%.

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Amount Held By ECB = 35% of total


BNDX Also Holds The 96 Year Austrian (“Tulip”) Bond

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100 Year “Tulip” Bond

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Risk Premium in Euro Term Structure Is Positive (Subtracting a Small Negative from a Large Negative is Positive)

Estimation of Risk Premium from two factor affine term structure model. Source: LongTail Alpha

At Negative Yields, Even With Moderate Inflation Investors Will Likely Lose A Significant Amount Of

Purchasing Power

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At negative 1% yield and 2% inflation the purchasing power of a dollar is only half in 30 years and almost zero in 100 years.

To derive this table we used the future value formula 𝐹𝑉 = 1 + 𝑦 𝑛 and assumed annual compounding for illustration.



YEARS

$1 1 10 30 50 100

5.00% 1.05$ 1.63$ 4.32$ 11.47$ 131.50$

2.00% 1.02$ 1.22$ 1.81$ 2.69$ 7.24$

YIELD 0.50% 1.01$ 1.05$ 1.16$ 1.28$ 1.65$

0.00% 1.00$ 1.00$ 1.00$ 1.00$ 1.00$

-0.50% 1.00$ 0.95$ 0.86$ 0.78$ 0.61$

-1.00% 0.99$ 0.90$ 0.74$ 0.61$ 0.37$

-3.00% 0.97$ 0.74$ 0.40$ 0.22$ 0.05$

Low Yields Have Encouraged Large Scale Stock Buybacks Boosting Stock Markets

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Source: Yardeni ResearchFOR EDUCATIONAL USE ONLY

Negative Yields Have Supported The Growth of A Short Volatility Ecosystem

• Long horizon investors

• Sovereign wealth funds Sellers and modulators

• Endowments and pension funds Sellers and modulators

• Medium horizon investors

• Yield-enhancing large asset managers Sellers

• Risk-parity hedge funds Modulators

• Risk premium harvesters Sellers and modulators

• Target volatility funds and variable annuity funds Modulators

• Short horizon investors

• Trend followers Modulators

• Volatility ETF and ETN investors Sellers

• Option market makers Sellers

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Which Frequently Implodes


Prepared for Q Group June 14, 2021. Confidential and Not For Public Distribution. LongTail Alpha, LLC.

29FOR EDUCATIONAL USE ONLY

Growth vs. Value

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Source: Citibank

Negative Yields Have Been Very Bad For European Banks

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GS

DB


“You're basically kicking a wounded

animal while it's down. Negative

interest rates have simply annihilated

European banks."DANIELLE DIMARTINO BOOTH, CEO OF QUILL INTELLIGENCE

How negative interest rates helped turn

Deutsche Bank into a disaster

By Matt Egan, CNN Business

Updated 5:16 AM ET, Mon July 29, 2019


https://www.cnn.com/profiles/matt-egan

https://www.cnn.com/business

Since Call Options on Low Priced Stocks Are The Optimal Expression of Upside Asymmetry Low Yields Also Support Meme Stock Effect. Resurgence of Retail Call Options Trading. Call Options on Low Price Stocks Are “Compound Calls”

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2

1

.rT N dKe

S N d


Call Option Leverage

Consequences of Negative Yields 1

•Monetary – Fiscal Stimulus

•Wealth Effect/Balance Sheet Repair

•Debt Reduction for Borrowers

• Inflation (Positive?)

•Other:•Growth vs. Value?


33


Consequences of Negative Yields 2

• Guaranteed loss of principal if held to maturity• Bonds as insurance policies not investments

• Correlated impact on risky asset prices• Rising NPV of ALL cash-flows results in potential of correlated selloffs so

diversification does not work as well

• Excessive risk taking• Encourages shadow financial insurance

• Large ecosystem of “short volatility strategies” that result in market instability

• Upsets the financial equilibrium and plumbing of the financial markets, e.g. repo market episode of September 2019

• Record Corporate Buybacks of Equity• Growth vs. Value

• Negative Yields are helping drive banks out of business

• Retail Speculation, Especially in Call Options of Meme Stocks

• Impact on inequality/social unrest?


34


Strategic Implication 1: “Shorting Risk Premium”

• When bonds are trading below par, a long-term investor earns premium by buying the bonds,

• But when bonds are trading way above par, as they are in much of Europe, a long-term investor might consider selling or shorting bonds to earn risk-premium!

• This is obviously not risk-less, since it can result in significant mark to market risk and volatility.

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Strategic Implication 2: Long Volatility

• When bonds are trading at negative yields, the discount factor makes the net present value of all cash flows higher than it would otherwise be.

• This raises the risk that any shock to yields results in an unwind of levered risky asset portfolios and loss of diversification benefits

• Further, this potentially means a sharp rise in volatility if markets de-lever simultaneously

• Considering how low volatility currently is, a long-term investor would be prudent to possess optionality and precautionary liquidity

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Pu

bli

c D

istr

ibu

tio

n.

Lo

ng

Ta

il A

lph

a,

LL

C.

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Strategic Implication 3: Fatter Tails and Trends

• When large excesses in financial markets are unwound, mean-reversion breaks down and is replaced by sustained momentum driven trends and fat tails

Pre

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red

fo

r Q

Gro

up

Ju

ne

14,

20

21.

Co

nfi

den

tia

l a

nd

No

t F

or

Pu

bli

c D

istr

ibu

tio

n.

Lo

ng

Ta

il A

lph

a,

LL

C.

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Conclusions

• The effect of negative yields are like the proverbial frog being boiled slowly. Investors might have collectively gotten used to this “Normalization Of Deviance”, and might not notice how strange it is for one to lend to lose for 30 or more years.

• History is replete with examples of such extremes being justified by the academic experts of the day , i.e “this time is

different”. When normalcy returns, we usually shake our heads in retrospect and say “what were we thinking”?

• For long term investors who are willing to step up and stand the mark to market volatility, this may be a once in a generation opportunity. Remember no one wanted to buy bonds at 15% yield in the 1980s!

Pre

pa

red

fo

r Q

Gro

up

Ju

ne

14,

20

21.

Co

nfi

den

tia

l a

nd

No

t F

or

Pu

bli

c D

istr

ibu

tio

n.

Lo

ng

Ta

il A

lph

a,

LL

C.

38


The Incredible Upside-Down Fixed Income Market: Negative ...

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