Eurozone government bonds are challenging fundamentals
The Eurozone (FEZ) bond market is challenging the very fundamental of bond investing. Sovereign bonds in many of the Eurozone’s economies are charging interest from bond holders—instead of paying interest. Last week, two countries put their names down in the history of bond investing. Switzerland sold $237.2 million of its sovereign ten-year bonds carrying a negative yield.
Sovereign yields in the Eurozone were already demonstrating a declining trend. The ECB’s (European Central Bank) bond buying program started in March. It pressured sovereign yields more. Now, they’re entering the negative territory more. Since the program is slated to end in September of next year, the yields could continue to remain low. The excess liquidity could support European equities (FEZ).
25% of Eurozone government bonds at negative yield
Currently, about 25% of Eurozone government bonds trade at a negative yield. The rest are also playing around the positive to negative border. Yields on the ten-year German, Swiss, and French bonds are currently at 0.2%, -0.1%, and 0.5%, respectively. Germany’s (EWG) two-year bonds are currently quoting a -0.277% yield.
Sovereign bonds in France up to three years, in Germany up to eight years, and in Switzerland up to ten years are all carrying negative yield. Interestingly, the trend also caught on to corporate debt. Yields on bonds issued by Nestle SA (NSRGY) and Roche (RHHBY) touched negative territory in February. Deutsche Bank’s (DB) covered notes maturing in 2018 also paid a visit to the negative yield regime in February.
Bonds issued by other European companies like Royal Dutch Shell Plc (RDS-A) and Novartis AG (NVS) have also been seen flirting around the negative territory. US firms like General Electric (GE), Philip Morris (PM), and McDonald’s (MCD) borrowing costs have also been verging on turning negative in Europe.
Negative yields make sense in a deflationary environment
Negative yields make sense to investors only in a deflationary environment—like the Eurozone. Under deflation, real yields on a sovereign bond quoting a negative nominal yield can be positive. Real yields are the nominal or quoted yields on the bonds, adjusted for inflation. Since inflation can be negative under deflation, it may turn an otherwise negative yield to a positive one when adjusted for negative inflation. This means investors stand a chance to gain, even though they may hold a bond with a negative yield. You may want to read Less Than Zero: The Implications of Negative Interest Rates for deeper insight into the topic.