Punting on a trade that’s guaranteed to lose
For the first time in at least 5,000 years, we have driven interest rates below zero. But, to many people’s amazement, demand for negative yielding government debt remains strong. Clearly, we are in unchartered territory, and we can only speculate on what lies ahead.
Successful investors are adept at deploying capital into opportunities that are capable of producing favourable returns over time. A value investing approach seeks to achieve these above-normal returns through buying securities for less than they are worth. This concept is simple but it is not easy. The difficulty – and this is where intense debate can enter the investment realm – is that the intrinsic value of a company is unobservable. This is distinct from the share price, which can be viewed at any time. Rather, intrinsic value is an estimate of the value of a firm based on the cash flows the firm is likely to produce over its lifetime.
Ask any two investors to come up with an estimate of how much a company is worth and you might receive wildly different answers. Investors labour under the setting of an uncertain world where their interpretation of the facts of a company may differ, but all investors are united in their desire to put money to work and generate a positive return. With this in mind, would an investor ever make an investment that they know is guaranteed to lose money?
Seemingly, the answer is yes and this is symptomatic of financial markets entering unprecedented times. We are in a situation where the monetary improvisation by central banks globally to stimulate growth has distorted the pricing of risk. Interest rates globally are at record lows and an alarming 80 per cent of developed market sovereign bonds are yielding less than 1 per cent.
It is in this context that there are negative yielding sovereign bonds which offer a guaranteed negative return if held to maturity. What this means is that rather than an investor being paid interest to bear the risk of holding that government bond, the opposite occurs, and investors essentially must pay for the privilege of lending their money to the government.
James Grant, a seasoned commentator on interest rates and author of Grant’s Interest Rate Observer, has commented that this is the first time in at least 5,000 years that we have driven interest rates below zero. So why might people now be purchasing negative yielding government debt?
There are a number of possible reasons: (i) risk-averse investors may view the negative interest rate as an insurance premium for parking their money in relatively safe government bonds, as opposed to depositing their money in a bank; (ii) investors may have expectations for a future deflationary environment, which would allow even negative yielding debt to earn a positive real return; (iii) if investors expect interest rates to fall further then they may be able to realise a capital gain on this negative yielding debt as the bond price increases; and (iv) central banks, insurance companies, pension funds and other institutions are required to purchase government bonds, regardless of the return or whether they are negative yielding.
Whether we agree or disagree with these reasons is irrelevant. What is clear is that interest rates globally have ventured into unchartered territory, and there does not yet seem to be a clear path back to financial normality.