Negative yields on bonds are back with a vengeance. The five-year German government bond yield reached an all-time low of ‑0.69% after European Central Bank (ECB) President Mario Draghi delivered a dovish speech on 18 June, indicating that the ECB could provide additional stimulus if economic downside risks increase and the current inflation outlook remains subdued. This triggered a fall in bond yields globally, with a record of more than US$12 trillion of bonds trading at negative interest rates as of 19 June (see chart). Negative yields mean investors have to pay (rather than being paid) for owning these bonds.
While investors might be satisfied with positive returns from falling yields in the rearview mirror, the picture is quite different when looking ahead. Negative yields represent a significant challenge for investors in traditional benchmark-oriented strategies. The yield on five-year German bonds, for instance, would reduce invested capital by 0.69% each year, or approximately 3.45% over five years. With these negative yields embedded in the respective benchmark-oriented strategies, we believe investors should be exploring alternatives.
Lower compensation per unit of risk
In addition to falling rates, benchmark-oriented investors may be exposed to higher market risk, which is reflected in increased interest rate duration for traditional strategies. Duration measures a bond’s price sensitivity to changes in interest rates, and the duration of the Bloomberg Barclays Global Aggregate Index, for example, has increased by 25% since 2010.
A more flexible investment approach may offer value
Allocations to more flexible strategies are one option investors could consider to address the challenges of negative yields. Well-designed flexible bond strategies can help navigate even the most challenging markets by identifying attractive investments from a global opportunity set while seeking to ensure investors receive appropriate compensation for the risk. In the context of negative-yielding assets, this also means steering clear of markets where risks may outweigh future return potential. Compared with traditional benchmark-oriented strategies, which are anchored to an index, the flexibility of a dynamic strategy may allow for a more patient approach and the maintenance of dry powder to deploy during periods of future market volatility and dislocations.
For investors facing the challenges of a low-yield environment, dynamic strategies with attractive risk-adjusted return profiles, flexibility, and low correlations to core bonds and equities may offer a compelling complement to core bond allocations.
Learn more about the potential benefits of dynamic bond strategies in “Unconstrained, Not Unpredictable: Best Practices for Flexible Bond Strategies.”