A few days ago over five billion dollars worth of Zero Coupon German government bonds (“Bunds”) were auctioned at a yield of minus five basis points. For me, as for many others, bonds with negative nominal yields hold a fascination – they are no longer unicorns, but nonetheless a rather rare animal in the history of money. Are they investments? Or as I see it – insurance?
From a pure finance point of view, what is remarkable about the recent Bund auction is the pureness of its information content for what investors are willing to pay for “insurance” against economic stress. Mathematically a zero coupon bond is the purest financial instrument there is. We multiply any future cash-flow by the price of the zero-coupon bond to compute the net present value (NPV) of the cash-flow – this is the foundation of all finance. Zero coupon bonds are the “quarks” of the financial marketplace. They are indivisible, and they form the basis for the time value of money, which today of-course seems upside down!
This zero coupon bond price today looks like insurance, smells like insurance, and walks like insurance. The 10Y maturity bund (technically the DBR 0% 08/15/2026) will pay no coupon to the holder, ever! But since it was issued at a negative yield (which would require the investor to pay to the German government), the investors who bought it paid 100.48 to receive 100 at maturity in August of 2026. So on issuance date, the investor is locking in a sure loss of 0.48 Euros, or 0.48 Euros of insurance premium.
As time passes, the value of the insurance will fluctuate with demand, and can even go up. But at maturity, the holder will get no more than 100. Insurance, as we know, is an option contract, and like other option contracts, when this Bund pulls to par, the value of the option premium will go to zero. For the first time in my memory, we can measure this long term option premium in the bond markets without any calculations – just look up the price of the zero coupon Bund and subtract 100 from it. Since the “duration” of a zero coupon bond is almost exactly its maturity, we can also figure out the risk in our heads. For a 10 year zero coupon Bund, the duration is 10 years, so a 1% rise or fall in yield is approximately a loss or gain of 10% in price!
A bond (or Bund) where you pay a premium to own it and receive no coupon income is not an investment asset, it is an insurance asset. The immediate question is: insurance against what exactly? While I do not know with certainty, one reason could be an anticipation of a drastic slow-down in future growth prospects, which would be accompanied not only by garden variety corporate defaults, but more alarmingly defaults by sovereigns who are not issuers of the bond in question.
Now there are also German Bunds maturing in 2018 and in 2021 that carry zero coupons, which trade well above par. We can see two things: first, the price of insurance has gone up since earlier this year as yields have gone more negative (which makes sense given Brexit). Second, investors are willing to pay a higher premium for the shorter maturity securities than the longer ones.
This suggests that market participants expect more risk in the short term than in the long term (an alternative interpretation which ultimately leads to the same conclusion is that investors are in need of a larger amount of short term securities which are rapidly disappearing due to Central Bank buying, which is reflected in shorter term yields being more negative). This “term-structure” of insurance might mean that the market expects more turbulence in the near future, and conditional on us coming through this period unscathed, less turbulence further out (but turbulence nonetheless).
From the lens of where we think of bonds as investments and not insurance, the situation is indeed perverse. But before we jump to conclusions, let’s recap the history of how we got here. GCBs (Global Central Banks) reacted with a flood of money to the GFC (Global Financial Crisis) and when that seemed to quit working, expectations were managed by assuring the markets that rates would not rise if the market got into trouble (we have seen at least three such events where the Fed changed its mind in the last year).
From an investor perspective, it made eminent sense to hold risk assets given this implicit protection (i.e. buy equities), but also hold insurance against that risk (i.e. hold bonds or protective put options). The net result since the financial crisis has been incredibly profitable for asset owners – but predictable. Holding equities and bonds (pretty much of any kind), has been “having your cake and eating it too”. Both stocks and bonds went up in value, by a huge amount, while still providing diversification on days when it was needed. It truly has been an asset owner’s paradise.
I hasten to add that buy and hold investors did really well in this environment, while the “smart money” struggled, since it thought (and continues to think) of bonds as only investments, forgetting their insurance-like characteristics. No wonder fees have come under attack. It’s like the local high school team beating the world champions.
From a purely mathematical point of view this simultaneous rally in both stocks and bonds is not a surprise, right? The discount factor was boosted up above par, so all asset prices rose since the present value of all asset prices has the same discount factor. The argument that this dynamic of all asset prices going up should stop when yields get close to zero also has lost some of its appeal, since in the short term, at-least, yields can go even more negative. Though we suspect that at least in Euroland, to “hedge” the risks of the equity market fully, yields would have to be minus two percent. Possible? Yes. Probable? Less so.
So should we worry?
Yes, we should worry not only about the risks from standing in the face of a “demand surge” in the need for the bond market as insurance. We should also worry that once the last bond pessimist has thrown in the towel and capitulated to the recognition of bonds as instruments of safety, and yields breach new lows, cross-market pricing will bring forward other substitutes to the insurance benefits bonds provide. Then bonds will certainly be orphans, and then, yields, look out above!
But until that happens, Bonds, and Bunds, are fine insurance policies, and one simply does not know what the limits of risk-aversion driven demand are. Just don’t think of them as investments.
Whatever the outcome, for the first time in this author’s experience, we can just look at the price of long term zero coupon bonds to figure out what the market is willing to pay for economic catastrophe insurance.
Vineer Bhansali, Ph.D. is the Founder and Chief Investment Officer of LongTail Alpha, LLC, a CFTC registered CTA and CPO. Any opinions or views expressed by Dr. Bhansali are solely those of Dr. Bhansali and do not necessarily reflect the opinions or views of LongTail Alpha, LLC or any of its affiliates (collectively, “LongTail Alpha”), or any other associated persons of LongTail Alpha. You should not treat any opinion expressed by Dr. Bhansali as investment advice or as a recommendation to make an investment in any particular investment strategy or investment product. Dr. Bhansali’s opinions and commentaries are based upon information he considers credible, but which may not constitute research by LongTail Alpha. Dr. Bhansali does not warrant the completeness or accuracy of the information upon which his opinions or commentaries are based.