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Negative yields in Europe: you’ve just got to ‘roll’ with them

Negative yields in Europe: you’ve just got to ‘roll’ with them

Times are tough for investors in Europe at the moment. Expected returns on all investments are low, while negative yields are pervasive in euro government bonds.

The numbers might be surprising: currently over 15% of all nominal Eurozone government bonds outstanding have a negative yield, down from around 30% at the peak in April. In Germany, yields are below zero for bonds under four years maturity, 34% of the total. In April, this stretched as far eight years maturity. Yields may have risen since, but remain low.

However, even without worrying about whether prices could go up further as yields fall, the return expected from bonds is more positive than you might imagine. We can put numbers to this as well.

It’s easiest to think of returns on bonds in terms of yield-to-maturity – the annualised return you make on an individual bond if you buy today and hold it until it matures. And yield is a useful number for describing a bond: it is meaningful, easy to calculate, and good for tracking day-to-day market movements. However, despite its many uses, yield is not well suited to describing multiple bonds in a portfolio. In particular it is a fairly poor metric for expected returns from a bond portfolio, and at lower yields this is increasingly the case.

Why are portfolios different from individual bonds? Carefully managed bond portfolios are “rebalanced” frequently to maintain the average maturity of bond holdings. A gradual but never-ending process of selling shorter dated to buy longer dated bonds is required. Time passing shortens the maturity of each bond, but bond managers keep their portfolios more-or-less constant.

Usually, longer maturity bonds have a higher yield than shorter maturity bonds, reflecting greater uncertainty over longer horizons. This would be described as an “upward sloping yield curve”. Yield curves map the relationship between yields and maturity, as seen in the chart below. As time passes and maturity reduces, an individual bond “rolls” down the yield curve, so the yield falls and the price rises. Rebalancing can be thought of as selling high priced and buying low priced bonds, and consequently increases returns if the yield curve is upward sloping.

German bunds

Source: Bloomberg, 11 May 2015’

Interestingly, this happens even when yields are negative. In fact, a whole portfolio of bonds with negative yields could have a positive expected return if this “roll” component is large enough – as is the case with four year German bonds at the moment.

Negative yields don’t necessarily equal negative returns

And so, even when investors’ backs are seemingly against the ropes, it’s still possible to ‘roll’ with the yield punches being thrown by the market. Ultimately, it’s important to remember that, despite the recent volatility and their appearances, negative yields don’t necessarily equal negative returns.

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