Record low European debt yields are unsustainable

In the past four years, the UK, US and Europe have pumped more than USD3,000 billion in to their economies by expanding central bank balance sheets. Unable to reduce record-low interest rates any further, their aim has been to encourage economic growth by increasing the amount of cash in circulation, keeping borrowing costs low and reviving consumer spending.

The success of this tactic is still a matter of debate, but one clear consequence of quantitative easing is that it has unnaturally pushed up the market price of government debt and, in turn, pushed down yields.

During the past two years, returns on five-year euro-area bonds have fallen to about 0.6 per cent from 2.75 per cent, hitting a record low of 0.24 per cent in 2012. Yields on debt with longer tenors have also plummeted, to 1.5 per cent from 3.5 per cent over this period for German bonds. In many cases, issuers are achieving negative real yield on their debt. This means the yield they are paying to investors is lower than the rate of inflation.

There is differentiation between yields on debt sold by countries in southern Europe, where the economies are more embattled, and those in the relatively more stable economies of northern Europe. For example, Spanish bond yields rose to 7.5 per cent in late 2010 and then dropped to 5 per cent, which is still well above the ten-year German bond yields.

This is a flight to quality in the euro region. Investors are afraid of the risk of the eurozone falling apart. This has created re-denomination risk in Europe, which we continue to see with lower rates in the northern zone compared to southern Europe. The north is benefiting from the issues in the south because investors can exchange sovereign risk for sovereign risk without leaving the currency. One could argue that the south is now in fact transferring value to the north.

The central bank actions have created a fantastic market for any issuer who needs to raise money from the capital markets. As long as they have a good credit profile, borrowers can raise long-term debt at extremely low prices from a diversified set of investors, as seen by Germany selling EUR184 billion of bunds last year alone. It makes sense for issuers to go for long maturities and lock in low interest rates.

However, the question has to be asked that if it is beneficial for issuers to lock in low interest rates for a long time by selling bonds, what are the benefits of fixed-income investors buying those bonds?

Quantitative easing means that the current low bond yields are not the result of normal market dynamics. They are artificial. Buyers need to be cognisant that they are investing in yields that have almost nothing to do with the strength of the underlying paper and almost everything to do with the extreme environment we are operating in.

The risk lies in the current extreme environment normalising. This is likely to occur when real interest rates rise and central banks stop buying debt and when the prices and yields of debt are once again determined by market movements and not by central bank bond-buying. Sustainable yields are, in my opinion, yields that cover for expected inflation plus a real return. When this will once again be the case is impossible to forecast because it is largely dependent on policymaking.

When normalisation does happen, which it most certainly will, the value of bonds will fall and yields will increase. This means the marked-to-market value of billions of euros of debt held in investors’ portfolios will drop, perhaps some sharply. The risk is that investors will have locked away funds in long tenors at then below market returns.

It’s easier to say what will trigger normalisation than when it will occur. One such trigger is likely to be that the euro will stay together and overcome its current issues. In my view, it will also be the advent of greater fiscal integration of Europe and perhaps the introduction of eurobonds.

Normalisation will not happen gradually. It will be a sudden, step change marked by the willingness of investors to sell the north and buy in countries such as Italy, Spain and Ireland. This will cause yields to average and it will normalise the division that we have today.

So why are fixed-income investors buying European debt in almost record numbers? Quite simply, there is no alternative. Theoretically, if you expect rates to go up, then you would only invest in short-dated securities. However, yields on this debt are so low, it is not worthwhile. Yields on long-dated sovereign bonds offer the most attractive risk-reward for investors, even if the risk of investing in yields that are below the rate of inflation will pose problems in the future.

Pension funds are among investors that may be at the greatest risk because they buy long-dated securities to match their long-dated liabilities. If a pension fund holds an asset which goes down in value because of rate changes, and that movement is not properly hedged, the coverage ratio (or the value of the asset versus the liability) will go down. In addition, when hedging rate risk, investors have to bear in mind counterparty risk.

The difficult decision investors are being forced to make unfortunately has no easy solution. However, being aware that bond yields are, by nature of the extreme economic environment, artificial and as a consequence the risk-free rate may not be risk-free after all, should be discussed and debated in investment committees across the globe. 

For more RBS Insight content, click here

Disclaimer

The contents of this document are indicative and are subject to change without notice. This document is intended for your sole use on the basis that before entering into this, and/or any related transaction, you will ensure that you fully understand the potential risks and return of this, and/or any related transaction and determine it is appropriate for you given your objectives, experience, financial and operational resources, and other relevant circumstances. You should consult with such advisers as you deem necessary to assist you in making these determinations. The Royal Bank of Scotland plc (“RBS”) will not act and has not acted as your legal, tax, regulatory, accounting or investment adviser or owe any fiduciary duties to you in connection with this, and/or any related transaction and no reliance may be placed on RBS for investment advice or recommendations of any sort. RBS makes no representations or warranties with respect to the information and disclaims all liability for any use you or your advisers make of the contents of this document. However this shall not restrict, exclude or limit any duty or liability to any person under any applicable laws or regulations of any jurisdiction which may not lawfully be disclaimed.

Where the document is connected to Over The Counter (“OTC”) financial instruments you should be aware that OTC derivatives (“OTC Derivatives”) can provide significant benefits but may also involve a variety of significant risks. All OTC Derivatives involve risks which include (inter-alia) the risk of adverse or unanticipated market, financial or political developments, risks relating to the counterparty, liquidity risk and other risks of a complex character. In the event that such risks arise, substantial costs and/or losses may be incurred and operational risks may arise in the event that appropriate internal systems and controls are not in place to manage such risks. Therefore you should also determine whether the OTC transaction is appropriate for you given your objectives, experience, financial and operational resources, and other relevant circumstances.

RBS and its affiliates, connected companies, employees or clients may have an interest in financial instruments of the type described in this document and/or in related financial instruments. Such interest may include dealing in, trading, holding, or acting as market-makers in such instruments and may include providing banking, credit and other financial services to any company or issuer of securities or financial instruments referred to herein.

RBS is authorised and regulated in the UK by the Financial Services Authority, in Hong Kong by the Hong Kong Monetary Authority, in Singapore by the Monetary Authority of Singapore, in Japan by the Financial Services Agency of Japan, in Australia by the Australian Securities and Investments Commission and the Australian Prudential Regulation Authority ABN 30 101 464 528 (AFS Licence No. 241114) and in the US, by the New York State Banking Department and the Federal Reserve Board. The financial instruments described in this document are made in compliance with an applicable exemption from the registration requirements of the United States Securities Act of 1933, as amended. In the United States, securities activities are undertaken by RBS Securities Inc., which is a FINRA/SIPC (www.sipc.org) member and subsidiary of The Royal Bank of Scotland Group plc. Dubai International Financial Centre: This material has been prepared by The Royal Bank of Scotland plc and is directed at “Professional Clients” as defined by the Dubai Financial Services Authority (DFSA). No other person should act upon it. The financial products and services to which the material relates will only be made available to customers who satisfy the requirements of a “Professional Client”. This document has not been reviewed or approved by the DFSA. Qatar Financial Centre: This material has been prepared by The Royal Bank of Scotland N.V. and is directed solely at persons who are not “Retail Customer” as defined by the Qatar Financial Centre Regulatory Authority. The financial products and services to which the material relates will only be made available to customers who satisfy the requirements of a “Business Customer” or “Market Counterparty”.

The Royal Bank of Scotland plc acts in certain jurisdictions as the authorised agent of The Royal Bank of Scotland N.V.

The Royal Bank of Scotland plc. Registered in Scotland No. 90312. Registered Office: 36 St Andrew Square, Edinburgh EH2 2YB.