Bizarro World

I remember reading Superman comics and loving the concept of a Bizarro World. In Bizarro World there is a bad Superman living in a planet called Htrae (“Earth” backwards) using his great powers to rule over the weak. As a child, I wondered, is there a reverse Bizarro World? I never thought that I actually lived in Bizarro World; however considering what is going on in the bond market, I might be wrong.

Wikipedia describes Bizarro World as “a situation or setting which is weirdly inverted or opposite to expectations”. That is exactly what is happening. Call it central bank manipulation or whatever you want, but negative rates are just bizarre to me. A negative rate bond is a bond where an investor is buying at a price which will guarantee a loss for the bond holder if the investor holds to maturity. This negative return includes the bond coupon. Currently, there is approximately $15 Trillion in negative rates with most of the negative rate bonds residing in Europe and Japan. Many of the newly issued negative rate bonds are issued without a coupon, and the bondholder buys the bond at a premium. The examples below illustrate what a 10-yr negative rate bond could look like:

Bond Yield Chart

As you can see, the negative return is not determined by the coupon but the price the investor pays. Either way, the total return if held to maturity is a loss and hence why it is called a negative rate bond. Why the heck would anyone buy a bond knowing they will have to pay the issuer? First, let’s take away the passive index funds. While many international passive bond funds own these bonds, they don’t set the price. Believe it or not, there are active bond investors purchasing these bonds and setting the price. Some investors buy these bonds thinking that negative rates will go even more negative, thus they will make a profit selling the bond at a higher price. Other investors buy it thinking that this negative return is safer than other assets. The first is using the greater fool theory and the second, in my opinion, is a loser mentality that accepts a pre-determined loss on their money. And, it is not just 10-year bonds that are negative yielding but the German 30-year Bund is negative as well. 30 years of slowly losing money, where do I sign up?

There is a lot of banter by equity bulls in the U.S. that say U.S. equities are much more attractive than treasuries as the dividend yield is higher than the yield on treasuries. If this thesis is correct and I have mixed opinions on that, then Euro area stocks are significantly undervalued relative to government bonds than at any other time in history. Right now, the MSCI Euro Index yields 2.73% and 323 basis points (3.23%) higher than the 10-yr German Bund. If you consider a below average dividend growth rate of 1.50%, a European investor could lose 35% of their equity value in 10 years and still come out even versus holding a 10-year Bund; Imagine that, you lose 35% of your purchase price, and still come out even with the 10-year Bund! BIZARRO WORLD indeed. In general, I do not like making strong binary decisions like being all-in, but in Bizarro World with negative rate bonds, I would be extremely tempted knowing I had a 35% equity value cushion. I like those odds. In fact, if I was a European investor or hedge fund, I would be shorting European bonds and buying European equities. In the short-term, the trade could be painful but it seems like a great set up for the long-term investor. After all, you are getting positive carry for the trade.

A money manager associate of mine has said that “the path of success can be destroyed by comparisons.” Right now, U.S. bond investors have pushed U.S. 10-year and 30-year rates to near or at all-time lows thinking a recession is right around the corner and rates will go even lower. As such these investors are willing to buy bonds that have a lower yield than U.S. 3-month T-bills and yield less than inflation. Yes, a U.S. 10-year bond seems really attractive at 1.50% compared to a German Bund; however, be careful of justifying an action because there is someone crazier.

Perhaps the U.S. will enter the Bizarro World of negative rate bonds and, as such, owning U.S. bonds would be a great investment. Personally, I would hate to see a world when those who saved can no longer get a nominal return on their savings. I also think that the day will come when investors will look back and say, “what were they thinking buying bonds with a guaranteed loss?”.

What’s the big risk of owning a negative rate bond? Something called inflation. Should inflation come, watch out. That’s is the reason we prefer owning shorter maturity bonds. Perhaps we lose a little upside in Bizarro World, but we will protect capital in a normal world. As always, we invest assuming the world is somewhat normal with short periods of abnormality.

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Disclaimer

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by LFC), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from LFC. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. LFC is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. A copy of the LFC’s current written disclosure statement discussing our advisory services and fees is available upon request. If you are an LFC client, please remember to contact LFC, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services.

Lee Financial disclaims responsibility for any public statements by any of its employees.  The views expressed herein are those of the author (Mark Whidby) through the period ending April 2019, and do not necessarily reflect the views of Lee Financial or of the author’s colleagues. These views are subject to change at any time based on market and other conditions. This is not an offer or solicitation for the purchase or sale of any security and should not be construed as such. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities.

2019-09-18T13:37:10+00:00