Who’d Be Crazy Enough To Buy An Asset With 100% Chance Of A Loss?

Who’d Be Crazy Enough To Buy An Asset With 100% Chance Of A Loss?
Stéphane Renevier, CFA

about 3 years ago3 mins

Mentioned in story

What’s going on here?

A quarter of all global government bond yields are now negative, with the remainder hanging around all-time lows. With that in mind, it’s hardly surprising that some investors might wonder whether it’s worth buying bonds at all – and if so, why. Let’s try to answer those questions.

What does this mean?

Put simply, there are two main reasons why an investor would want to hold even bonds offering negative yields: to speculate on interest rate movements and diversify risk.

📈 Speculation

Investing in a negative-yielding bond only guarantees a loss if you hold the bond to maturity. If you instead sell it on before repayment falls due, then your level of profit or loss will largely depend on which direction the market has moved in the meantime. Since bonds’ prices move inversely to yields, you can end up securing significant returns if yields have fallen further (or even not at all).

In fact, two technical properties mean some bonds number among the most sought-after weapons of speculation out there. The first, “duration”, is linked to the bond’s time to maturity. The further off that maturity, the higher a bond price’s sensitivity to changes in yields – and, therefore, the higher the profits if yields fall. The second characteristic, “convexity”, relates to bond prices’ ability to gain more if yields fall than they lose if gains rise by the same amount. And guess what? The lower a bond’s yield, the higher its convexity – making negative yielding bonds a very efficient way to bet on yields falling further.

Take the example of the 100-year Austrian bond, which exhibits both extremely high duration and convexity. When the Alpine state first issued these in 2017, some said buyers were “out of their minds” for accepting a mere 2.1% annual yield across the next century. Three years later, however, price movements had helped those bonds return more than 75% – more than double the gains of the US S&P 500 stock index over the same period!

Source: The Economist
Source: The Economist

🧺 Diversification

The other reason investors might be fond of negative-yielding bonds is that they tend to perform well when other asset classes – such as stocks, commodities, or private investments – struggle. As the chart below shows, yields have moved significantly lower during each of the past few major economic crises – periods in which riskier company shares, for example, generally fell in price.

US 10-year government bond yield movements during recent crises
US 10-year government bond yield movements during recent crises

But is history a good guide to the future? In my view, it’s hard to imagine a crisis scenario in which central banks don’t aggressively cut base interest rates (alongside other increasingly inventive measures) in a bid to prop up the economy. Whether it’s a recession, a financial shock, or a long period of deflation, I’d expect rates to move lower – and in such scenarios, bonds might be the only investment offsetting losses elsewhere in your portfolio.

An additional benefit is that bonds are highly liquid, making them even more valuable in times of crisis as a source of ready cash. We don’t question people’s readiness to pay premiums insuring their house against the risk of fire – so is it so crazy that there are investors willing to stomach on-paper negative yields in order to protect their portfolio should things head south?

Why should I care?

Many investors instinctively avoid bonds simply because their yields are low or negative. My opinion is that this attitude is short-sighted. As we’ve seen, even negative yields don’t necessarily translate into negative returns. Don’t get me wrong – I’m not suggesting that buying bonds is the trade of the decade (or even of 2021). Bond investors can still experience losses if rates rise sharply or inflation unexpectedly flares up. But what I will say is that you shouldn’t write off bonds as a total loss. When used in the right way, they remain a great weapon to have in your investment arsenal.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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