JP Morgan Asset Management Chief Market Strategist for Europe Stephanie Flanders comments:
“The clue ought to be in the name: fixed income. But that income is now harder to come by, and for large swathes of the European sovereign bond market, it has disappeared entirely. €1.4 trillion in bonds currently trade at a negative yield—approximately 25% of all European sovereign debt outstanding—implying that investors are willing to pay for the privilege of lending money to these governments. With this situation unlikely to change dramatically any time soon, navigating through it is probably the toughest task facing investors this year.
“What has caused this? First and foremost, the prolonged period of central bank bond buying globally has created an unprecedented demand for bonds, pushing prices higher and yields to extreme lows. Then global disinflationary pressures increased, mainly due to the strong decline of the oil price and falling long-term inflation expectations, creating more downward pressure on rates.
“Why are we stuck with it? The ECB’s QE plan will see it buy approximately 190% of net sovereign issuance in the eurozone in 2015, meaning there will be a fall in the supply of sovereign bonds available to investors – hence the spiral lower in yields.
“Most important, why should investors care and what does it mean for them? Unless you’re a bank or an insurance company which is effectively forced by regulation to own higher quality capital as a buffer against losses, then the only time you should ever consider buying negative yielding bonds is if you can expect to be rewarded in total return terms. At these levels, the upside potential for bond prices is clearly smaller than it was.
“However, ECB purchases and continued low inflation could keep eurozone bond prices at these elevated levels – and even push them higher from here. There is every possibility that if the economy or inflation expectations do not respond in the way the ECB expects, QE will be extended. In addition, there could be a scarcity issue in certain parts of the market, since the ECB is going to be buying more sovereign debt in 2015 than European governments will be selling. This was not the case in the UK and the US when their central banks undertook QE.”
Sooner or later, nominal and real rates will start to rise. This is sure to cause volatility and will mean capital losses—particularly for holders of long maturity debt.
Flanders says that diversified and flexible strategies are the best way to protect portfolios and to pursue the search for a more efficient risk/reward profile of bond investing. Investors should be ready to consider a wider range of fixed income options to put in their portfolios, including European high yield corporate bonds.