9 August 2016
An investment guaranteed to lose you money?
If you were offered the opportunity to buy a bond for £100.50, which pays no income, and on which you would only get back £100 in 10 years' time, would you take it?
A rational investor would likely answer 'no'. But markets and investors are acting irrationally at the moment, and that is exactly what is happening.
Mark Carney, the governor of the Bank of England, was keen to stress last week that he would not resort to negative interest rates, but that doesn't mean bond yields can't, and won't, go negative. We've seen this happen in Japan and, last week, it happened closer to home. The German government issued 10-year bonds at auction with a negative yield.
Why would an investor buy though? Craig Moran, a fund manager in the M&G Multi-Asset team, which supports the Elite Rated M&G Episode Income, says: “Our approach to investing involves seeking to identify and exploit markets behaving in an irrational manner.
“At first glance the transaction described above doesn’t seem like a rational one, but it’s important to challenge ourselves, as well as the market, to identify if we have a quarrel with its behaviour.”
As with all investments, there are of course some 'forced buyers' – investors that have no choice but to buy certain assets. For example, life insurers and pension funds, which track the bond indices and have to buy what is issued. But are there any reasons to buy these bonds if you don't have to?
So are there any rational explanations?
When the yield on a bond falls, its price rises, so one reason could be that the buyer thinks that they can sell it to someone else at a higher price at a later date (i.e. if yields get even worse, the current scenario starts to look desirable). However, whilst bond yields may have been defying the odds for some time and continue to fall, can they do so forever? We would suggest not.
It could also be that cash is yielding even less. Whilst we worry about how low interest rates could go on UK bank accounts, the current deposit rate for the European Central Bank (ECB) is -0.40%, so storing your money overnight with a European bank costs you money. That makes the German government bond yield at -0.10% look more attractive. We're talking about a 10-year bond though, so you'd need the interest rate to stay where it is for the full decade. It's a dangerous game to play. Whilst interest rates have been very low for a long time, even the expectations of an interest rate rise could significantly impact your returns. For example, if rate expectations move by more than 1% you could lose 10% on the price of the bond.
So is the fear of deflation the deciding factor? If investors think that the money they have today will be worth less in the future, the bond would seem like a good bet. However, given the ECB is doing everything in its power to avoid a deflationary environment - they don't want Europe to be the next Japan - this would seem an unlikely scenario.
That leaves the allure of the safe-haven asset. As Craig points out, one thing that most market participants would agree on is the fact that there is a high probability that you will get your money back if you buy these bonds – albeit slightly less than you initially paid. It seems today the most likely reason investors are buying this bond (and many, many others at similar yields) is certainty.
“This is where our biggest quarrel with the market lies,” concludes Craig. “Safety, or certainty, like everything else – has a price. A guaranteed negative return on an asset held for 10 years seems like far too high a price to pay today for this perceived safety.
“When it’s difficult to find any rational reason for buying something, should rational investors be thinking about selling it instead?”
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Craig's views are his own and do not constitute financial advice.