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Bulls, bonds and brain damage

There’s a dangerous impulsivity evident in both private equity markets and parts of the bond market that suggests a boom has morphed into a definable bubble. Whether it is from these markets that the next black swan or contagion emerges remains to be seen but bubbles they are, without doubt. In the first instance investors could do worse than rebalancing portfolios by reducing weights to these classes.

When the unthinkable become routine

Persistent negative yields on a growing quantum of sovereign bonds has captured the financial media’s attention. Today, US$17 trillion of sovereign bonds, or about 20% of global GDP, are trading with negative yields. Bonds issued by countries including Switzerland, Japan, Germany and the Netherlands now have negative yields and even dodgier credits such as Italy have negative shorter-term rates.

It has been enough to cause the central banks’ banker, the Bank of International Settlements, in the context of observing that monetary policy will become ineffective “should a downturn materialize” to note, “there is something vaguely troubling when the unthinkable becomes routine”.

Vaguely troubling is putting it lightly when one looks at junk-rated corporate bonds trading at negative yields. Yes, you read that correctly. A bond buyer who holds to maturity can only receive the face value of the bond and the coupon or interest payments. If the premium they pay above face value is greater than the sum of the remaining interest payments, they are locking in a loss.

Of course, if the issued bond is CCC-rated, there is the real prospect that the issuer defaults on their obligation to repay the face value. Typically, this not insubstantial risk is compensated for through a higher yield.

So the buyer of a negative-yielding corporate bond will lose money by holding to maturity and could also lose money if the company defaults. Investors surely cannot be that irrational.

Something else is going on

What is going on is pure unadulterated speculation. The buyer of a negative-yielding bond is simply hoping that rates head even more negative. The only way that can happen is if a bigger ‘fool’ pays a higher price for the bond and accepts an even greater negative yield.

Nobody wants to hold these bonds to maturity, and the buyer is obviously not expecting the company to default while they own the bond. Everyone trading these securities must therefore be expecting to have one last dance before the barn burns down. They’re expecting to be able to get out safely before they’re consumed.

Of course, now that these bonds are already negative yielding, someone has to lose, therefore some will. Whether or not it's brain malfunctioning, consensual hallucination or an intellectual short-circuit, it is rebadging speculation as investing.

So far of course, everyone who bought these bonds at higher yields has done well. In Europe, for example, according to the ICE BofAML Euro High Yield Index, the average yield on junk bonds is less than 2.90%. Anyone who purchased corporate high yield junk bonds back in 2012 when the index yield was at over 11% or in 2016 when the yield was above 6% has made a fortune.

To crystalise the profit, however, the owner has to sell and the new buyer must clearly believe yields will even be lower and more negative in the future so they can, in turn, sell to a similarly brain-dead or testosterone-fueled individual or institution.

European corporate bonds trading at negative yields this year include those issued by Ardagh Packaging Finance plc, Altice Luxembourg SA, Altice France SA, Axalta Coating Systems LLC, Constellium NV, Arena Luxembourg Finance Sarl, EC Finance Plc, Nexi Capital SpA, Nokia Corp., LSF10 Wolverine Investments SCA, Smurfit Kappa Acquisitions ULC, OI European Group BV, Becton Dickinson Euro Finance Sarl and WMG Acquisition Corp.

Elsewhere, it’s the terms of the bond that produces a negative expectancy. By way of example, earlier this month, the owner of the Tinder dating website, Match Group Inc. saw its 6.375% unsecured note trading at 105.35 cents on the dollar.

If these bonds were held to maturity in 2024, they would yield approximately 5% but the yield achieved on these bonds could be much lower because the bonds became callable in June of this year. In other words, at any time, Match can redeem the bonds by paying investors a modest premium over face value. If Match took advantage of today’s speculative frenzy to refinance the bonds, the actual yield would be minus 0.20%. For an online dating site!

Private equity values will come back to bite

The insanity being displayed among negative-yielding, high-yield bond traders is also evident among private equity and venture capital punters.

That Uber even exists is a function of equally brain-damaged altruists. Evidence that its model is broken is the popularity being driven by an underpricing its main service. There is a negative return on its investment in technology and a negative return to its owners. Uber won’t exist in its current form in a decade.

You can predict a similar outcome for Tesla thanks to Porsche, Mercedes, Audi and VW’s announcement of production-ready electric vehicles at this year’s international motor shows. Tesla will be forced to cut prices in an attempt to maintain volume and losses will accelerate.

Then there’s Peloton, a company selling US$3,000 stationary training bikes with a US$39 monthly subscription to an app that links you to your favourite spin class. Think Ab Blaster or thigh master meets Jane Fonda on roller blades with a Nintendo Wii Fit in her hand. It’s a fitness fad whose offer will be on the council collection heap in years to come, seeking a US$8 billion valuation.

Fortunately, the more recent cancellation of the WeWork IPO – US$5 million paid to the founder for the right to use the word ‘We’ anyone (?) – is evidence that the bubble may have been popped.

History is replete with examples of investors losing their minds and believing the unsustainable is permanent. How it plays out is anyone’s guess but serious investors should look elsewhere. Cash may only offer a percent or two but that’s better than minus 50%. It all reminds me of Herb Stein’s quote: “If something cannot go on forever, it must stop.”


Roger Montgomery is Chairman and Chief Investment Officer at Montgomery Investment Management. This article is for general information only and does not consider the circumstances of any individual.


Ramon Vasquez
October 13, 2019

Hi .
Having missed all the downturns since before 1987, l now await the doozy of a slow decline with a one hundred per cent cash portfolio.
What more can l say, except best wishes to everyone. Ramon.

Ben Lebsanft
October 10, 2019

It’s a shame that all this “speculation“, it is not responsible for production! While it can be argued that finance helps, there is nothing economic about it!
The economy is not finance, but what happens each day in producing something and service as in making a cup of coffee etc, as if people don’t buy and sell real goods and services the economy just doesn’t work.
Finance has such a myopic view of itself, as the only thing it has to sell is risk, not anything fancy, as the marketers tells us.
It could easily be run on an algorithm that prices it and gets on with it at much lower costs.

Warren Bird
October 10, 2019

I respectfully disagree with much of what's in this article about corporate bonds, but the only issue I wish to comment on is to remind readers that the absolute yield is less important than the spread over alternative, less risky, investments. So to mention the European high yield index that Roger refers to - yes the average yield on the bonds in that index (nearly 500 securities, by the way, only 4 of which trade at a negative yield and they're short term) is around 3%. Sounds low. BUT corporate bond investing is always about the spread to risk-free, government bonds or the swap rate. And what Roger fails to mention is that this index is still paying investors nearly 4% more than government bonds. That's a little less than the long run historical average, but you'd expect that in a low default environment. And more important, it's still above the level that compensates investors for default risk.

The corporate bond market generally, and the high yield market specifically, is not priced as ridiculously as Roger's article implies. I'm not saying it's raging good value - it isn't. But 'brain damage'? 

October 11, 2019

I agree Warren - the other interesting thing is the introduction of chinese government bonds to the index globablly, in tranches. These bonds are yield over 3.5% as I understand it and will bolster any potential for negative yield bonds already in the index. Not great, but with cash where it is, not a disaster.

October 10, 2019

I agree whole-heartedly with just about all of that Roger, but I don't think Tesla is quite as clear cut. I wouldn't buy their shares, but the fact that Tesla is now pretty much break-even, and none of the announced offerings from other manufacturers even come close to the Tesla value proposition should give them some cause for optimism. In addition, if/when they actually crack the self-driving (especially if they are the first and/or best), then the huge additional automation cost that they have built into all their cars will pay off in spades as all those owners who haven't paid up-front suddenly start to send them even more cash.

Adam W
October 10, 2019

Hi, I would like to point out one additional key reason why investors would buy negative yield bonds that Roger has missed. A Japanese fund manager or a US fund manager (ie a large component of the global buyers of bonds) can buy negative yielding German (or other European) government bonds and swap this back into their home currency of JPY or USD and earn a yield in excess of their own government bonds ie JGBs or USTs. Adam

October 10, 2019

Where does the cash go then? No one wants to sit at negative real yields and so it's inevitable speculation will occur, and its clear they are going to keep supplying cash to the markets for some time? So why not speculate, it's cheap/free money. I know it will end poorly, but you might forgo 20-50% waiting - which is what many have done for some years now.

Anthony Gross
October 10, 2019

Well argued Roger. You have correctly identified some heavily over valued listed equities...But I think the real issue is if the current US Government bond rate goes from the current about 1.5% back to say 3%...…..for the ASX listed equity like Ansell ANN which according to the current ASX website it trading on an historic P/E of about 22 time and a dividend yield of about 2.5% unfranked...Is the cash price on the ASX going to go from the current about $26.25 back to say $23 or $19 or say $13 over the same time frame?
of how does one assessment the future intrinsic value of ANN or any current non mining stock as interest rates gradually normalise over the next 5 or 10 years?

from a long only equities manager...

October 10, 2019

Where does the cash go then? No one wants to sit at negative real yields and so it's inevitable speculation will occur, and its clear they are going to keep supplying cash to the markets for some time? So why not speculate, it's cheap/free money. I know it will end poorly, but you might forgo 20-50% waiting - which is what many have done for some years now.

October 10, 2019

Agreed. Up the elevator, down the lift shaft. When, what and how to short without risk?

Mark Hayden
October 10, 2019

Well said Roger. We are in fascinating times. For Bond Traders it is a zero-sum game. With negative yields the average Bond Trader/Investor will get a negative return. Interestingly everyone seems a winner for a while - traders sell at a higher price (and then buy back in whilst they "see" more gains) and investors show a gain with mark-to-market.


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