The value of the world’s negative-yielding debt has fallen by one-third from its August peak. What's the message for markets?
Between the end of August and mid- November, the total market value of debt with negative yields fell by one-third, from $17.03 trillion to $11.41 trillion,1 before rebounding slightly to $12.45 trillion (as of November 22). What has driven the drop, and what could it portend for the world’s bond markets?
Total Market Value of Negative-Yielding Debt vs. Germany and Japan 10-Year Yields
Source: Bloomberg, as of 11/25/2019. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
The most obvious factor is higher (i.e., less negative) yields in Europe and Japan, whose key central banks were pioneers in setting their respective policy rates below zero. The Bank of Japan cut its deposit rate from 0.10% to -0.10% in January 2016, followed by the European Central Bank (ECB) six months later in June, when it cut its deposit rate from 0.0% to ‑0.10%. In both cases, 10-year yields fell in response.
But the ECB’s most recent rate cut, to an all-time low of -0.50% in September has paradoxically coincided with the move toward higher European rates. The logic: the appeal of the relative safety of Europe’s bonds began to be eclipsed by a greater appetite for risk, underpinned by the ECB’s stated willingness to resume the aggressively accommodative policy begun by President Draghi earlier in the decade.
Japan’s bond market yields, in turn, began its own rise in September, as expectations rose about the Fed’s cutting its own target rate to 1.75% at the end of October.
It’s too early to tell if these recent risk-on signals will endure. But as economic figures in the U.S. have continued to sidestep signs of potential recession, some corners of its fixed-income and equity markets appear ready to give growth a chance.
On the rise: Private Credit “Unitranche” loans.
The rising number and size of asset purchases by private equity firms has been fueled, at least in part, by borrowing in the form of so-called “unitranches”, which combined first-priority and subordinated loans into a single offering taken up by a small number of large lenders.
Instead of segregating the lower- and higher-risk portions of a private equity purchase into separate groups, or tranches, each with its own ratings, risk profiles and price dynamics, unitranche loans aggregate the risk levels together in a single offering. The lenders, in turn, buy and sell amongst themselves the risks associated with different components of the loan, which risk sales and purchases can take the form of private-market credit default swaps. The result is that the risks, including bankruptcy risks, are laid off amongst the lenders in the form of what can be thought of as side transactions rather than between the lenders and the companies being financed.
All this makes it possible to consummate unitranche deals quickly, rather than shopping a variety of loan types in more traditional lending syndicates over time. It also provides a new way to satisfy the large and growing demand for products with attractive yields.
But the main disadvantage is clear – these side transactions aren’t explicitly linked to the assets, so in a bankruptcy of any part of the overall asset, claims against that part of the asset could be difficult to establish – which means that for both sides of any side-transaction, lenders could be exposed to risks for which they have no recourse. For some, this un-collateralized risk recalls some loans that were at the heart of the 2007-8 financial crisis – such as mortgage-backed debt.
On the slide: Japan Growth Forecast
For the third time this year, the International Monetary Fund (IMF) cut its forecast for Japan’s GDP growth for the full year 2019 to 0.8% from 0.9%, and to 0.5% for 2020.
However, this counts as good news for Japan’s Prime Minister Shinzo Abe, who has been assembling an aggressive stimulus package to counter the forces behind slowing growth – including repair of damage from October’s massive Typhoon Hagibis; an unpopular increase in the national sales tax; and the prospect of slowing global growth. In addition, the IMF’s policy recommendations for increased spending are broadly in line with the growing trend in developed economies to seek a combination of fiscal and monetary stimulus to boost growth, as the ability of monetary stimulus on its own to do the job appears to be waning.
Note: The year for all dates is 2019 unless otherwise indicated
1 Source: Bloomberg. Dates: Aug 29 – Nov 12, 2019. As measured by Bloomberg Barclays Global Aggregate Negative Yielding Debt Market Value Index (US$).
Definitions:
Unitranche debt is a type of structured debt that obtains funding from multiple participants with varying term structures. This type of debt is typically used in institutional funding deals. It allows the borrower to obtain funding from multiple parties which can result in decreased costs from multiple issuances, provide for greater fundraising through a single deal process and facilitate a faster acquisition in a buyout.
The International Monetary Fund (IMF) is an international organization of various member countries, established to promote international monetary cooperation, exchange stability, and orderly exchange arrangements.
Gross Domestic Product ("GDP") is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.
A credit default swap (CDS) is designed to transfer the credit exposure of fixed income products between parties.
A Mortgage-Backed Security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages.
The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
The federal funds rate (fed funds rate, fed funds target rate or intended federal funds rate) is a target interest rate that is set by the FOMC for implementing U.S. monetary policies. It is the interest rate that banks with excess reserves at a U.S. Federal Reserve district bank charge other banks that need overnight loans.
