The European Union hit the headlines last week when it borrowed €17billion, or £15billion, in ‘social bonds’, which would be dished out to member states to help them recover from the coronavirus pandemic.
Brussels’ first ever coronavirus-linked issuance sparked a feeding frenzy from investors, with demand for the debt of its 27 member states hitting a reported €233billion, or £211billion, enough to fill it 14 times over.
The majority of the issue was €10billion in 10-year bonds. It attracted €145billion of demand alone, which may appear remarkable considering it offered to pay investors a ‘negative yield’ of -0.26 per cent.
The EU, led by Commission president Ursula von der Leyen, raised billions of euros in ‘social bonds’ a week ago from investors to help fund the bloc’s recovery from the coronavirus
That is, investors queued around the block for the privilege of owning billions in investments which pledged to pay them back less than they invested in 10 years’ time.
‘In effect what is happening is you are buying a bond for a particular price, and you would expect when that bond is redeemed, for it to be redeemed at a price such that you will lose money over time in terms of investment’, Andrew Balls, chief investment officer at asset management firm Pimco, explained in a recent BBC Radio 4 documentary.
This is not a recent phenomenon, nor one unique to the European Union’s new coronavirus bonds, which mark only the first in a series of major multi-billion euro borrowing binges planned by Brussels over the next year.
Because for all the talk over the introduction of negative interest rates in the UK, billions of pounds of investments are already subject to them.
Rates on UK government bonds, or gilts, are negative on those with terms of up to five years, and the Treasury faces incredibly low borrowing costs across the board, meaning less of a return for investors lending it money.
Despite this, a net £144million was invested into UK gilt funds in August, according to the Investment Association, making it the eighth-best selling sector. And worldwide, a massive £12.8trillion of global debt is negative yielding, close to an all-time high.
Government bonds paying out little or even negative returns is ‘the reality around the world and has been for decades’, Jim Leaviss, chief investment officer at M&G Investments, said. ‘Even before the pandemic bond yields and interest rates were falling.’
All of this raises the question of why so much debt pledges to pay back less than what’s invested, and why on earth any investors are interested in buying it.
Some £12.8tn of global debt is now negative yielding, driven by sub-zero returns on European government bonds
Why do returns on bonds turn negative?
The returns on bonds, which are used by companies and governments to borrow money to fund expenditure, move inversely to their cost, and are usually a reflection both of demand and of risk, as This is Money has previously explained.
As investors flock to government bonds, which they often do in times of crisis as they are seen as a safe haven, the increased demand means prices rise and governments can get away with paying less, or even negative interest.
When there is less demand, governments have to pay a higher yield to tempt investors, and less creditworthy governments may also have to offer more.
Bond yields are low or even negative around the world thanks to a combination of a global savings glut driving down deposit rates, low-to-negative interest rates, low inflation, intervention from central banks and weak forecasts for economic growth, even before the coronavirus pandemic struck.
For many countries around the world, including Germany, France and the Netherlands, their governments can borrow money over a 10-year period at a rate which is negative
In the case of the new Brussels bonds, the European Central Bank has had negative interest rates for the last six years.
Pimco said negative rates are designed to spur banks and other investors into buying short-term government debt rather than lose money by keeping it in cash, which pushes up prices and lowers yields.
And aggressive bond buying programmes by central banks like the ECB, the Bank of England and the US Federal Reserve also serve to keep yields on bonds low and prices high, as they ensure there is always demand for the debt.
The European Central Bank has paid banks negative interest rates on deposits held with it since 2014, as it seeks to spur economic growth
‘Everything central banks are doing is designed to keep bond yields low’, Jim Leaviss added.
Sub-zero returns are therefore concentrated among EU nations as a result, with German bonds, ‘bunds’, the safest of havens for Eurozone investors, offering negative yields on investments of as long as 30 years, something which is not expected to change any time soon.
Rates on UK government bonds, or gilts, are sub-zero on bonds of up to 5 years, as central bank activity helps to depress yields
Mike Riddell, from Allianz Global Investors, said: ‘The market is pricing in negative yields for a long time in the Eurozone because of ongoing structural problems such as ageing demographics and high youth unemployment and high debt levels, which means weaker growth in future.
‘Even before the coronavirus crisis there was a distinct lack of inflationary pressure, which is an even bigger problem now. Investors don’t see any need for the ECB to hike rates for a long time, hence why yields are negative in the lowest risk bonds not just for the next year or two, but for many years.’
But if that’s the case, why is there any interest from investors, and record demand at that?
Investors might not have a choice
The first reason may simply be necessity. Banks and other institutional investors like pension funds, which look after billions of pounds and can’t safely stash that in a bank account or under a mattress, are often required to hold liquid assets which can be swapped for cash at short notice, as government bonds can.
As well as having to stay liquid, pension funds also hold assets like bonds so they can cover future payments. Britain’s largest private sector pension fund BT, for example, held £19billion worth of government bonds and cash at the end of June, 33.2 per cent of its portfolio.
A further 27.9 per cent was held in investment grade bonds, which together helped to cover 42 per cent of forecast future payouts.
Major pension funds like BT are required to keep a sizeable portion of members’ funds in safe assets like government bonds which can quickly be redeemed for cash and cover payments
They’re a safety deposit box
Another reason is safety. ‘You’re looking to buy a safe asset that isn’t going to go down as far as equities might do’, Andrew Balls added.
As stock markets once again slide as the world continues to grapple with the coronavirus pandemic, investors may look to bonds to act as a ‘brake’ on their portfolios to stop them falling further, as they tend to be less volatile.
‘It’s a little bit like paying a bank to give you a safety deposit, you know if you put in £100 you’d get £100 back in a year but you’d pay them £1 for the privilege of renting that security box’, Balls said.
Investors are therefore happy to park their cash in an asset with a top credit rating backed by 27 EU nations, and pay a small sum for the privilege.
The same could be said for US Treasury bonds or UK gilts, with both governments unlikely to be unable to pay back their debts.
‘Even if the income is low people want their security and to keep their capital safe’, Leaviss said.
Investors can still make money
There is also the fact that investors can still make a return on bonds even if they have a negative yield. Provided there is enough demand, they can be sold to benefit from a rise in bond prices.
UK gilt funds have returned 7.1 per cent since January despite the average yield on a UK gilt fund being just 1 per cent.
And with central banks purchasing hundreds of billions in bonds, investors may feel there is a backstop that is always there as a secondary market if they want to sell and a profit to be made.
‘The European Central Bank can buy up to half of any EU debt in its vast quantitative easing programs. Investors know there’s a backstop’, Marcus Ashworth wrote in Bloomberg.
Were Brussels’ returns actually good?
And lastly, perhaps the strangest thing about Brussels’ 10-year negative bonds is that they actually represented an attractive rate of return, despite their minus yield.
10-year German bunds, the Eurozone’s most risk-free asset, offered a return even deeper into negative territory, while AAA rated bonds, the most creditworthy and the same rating as those offered by the EU, from Eurozone nations averaged a yield of close to -0.6 per cent.
Therefore, in the topsy-turvy world of negative interest rates and negative yielding investments, simply offering a rate less negative was enough to spur demand from investors.
Although Brussels’ bonds paid a negative interest rate of -0.26% over a 10-year term, this actually represented a much better rate of return than that offered by other Eurozone governments
‘These new EU bonds were actually “priced to perform”, Mike Riddell said. ‘In other words, they offered a generous yield pickup over other AAA Eurozone bonds of similar maturities, and substantially more yield than that available from government bonds such as Germany or France.’
He added: ‘It was very important for this issue to be seen as a success, both politically, but also because there will be many more EU SURE bonds issued in the future.’
But while success for the EU is one thing, those lending it and other governments money may find it harder to achieve if they are on the lookout for positive returns.
With central banks unable to get close to their inflation targets, low prospects of economic growth and governments potentially holding investment returns below the cost of living in order to whittle down debts racked up during the fight against the coronavirus, investors may be paying for that safety deposit box for a long time yet.