Investing When Bond Yields Are Negative
Vineer Bhansali
Managing Director, Portfolio Manager
PIMCO
Q-Group Presentation
October 2015
This material is for presentation to Q-Group. It is for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. The references to “insurance” contained herein do not refer to traditional insurance related products , but rather portfolio management techniques employed for insurance like characteristics. PIMCO does not offer insurance guaranteed products or products that offer investments containing both securities and insurance features. PIMCO does not provide legal or tax advice. Please consult your tax and/or legal counsel for specific tax or legal questions and
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No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown. Hypothetical and forecasted performance results have several inherent limitations. Unlike an actual performance record, these results do not do not reflect actual trading, liquidity constraints, fees, and/or other costs. There are numerous other factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated or forecasted results and all of which can adversely affect actual results. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve
“A basic principle of Austrian economics is that the original rate of interest (the rate of discount of future
goods compared to the present, otherwise identical, goods) can never be negative. The reason for this arises
not because capital is productive, nor out of man’s psychology. Rather, it is embedded in the very concept
of human action.” Walter Block [1978].
“it may be time […] to go negative”, If lowering interest rates stimulates the economy and policy rates are
already very low or even zero, then why not keep cutting rates and have negative interest rates? The idea
of negative rates, that is, lending 100 and getting back say 95, may seem absurd “but remember this: Early
mathematicians thought the idea of a negative number was absurd [too]”. Benoit Coeure quoting Greg Mankiw [2014].
Explanations for negative bond yields
Negative yields as insurance
–The insured discount factor
–Impact of Risk aversion vs. subjective probabilities
Implications for Asset pricing, Risk Premia, and Diversification with negative yields
A simplified framework
Technical reason 1: Supply
-demand imbalance
–Sovereigns buying up all the float of existing bonds
Technical reason 2: Indexation of bonds markets
–Preferred habitats of investors
Economic reason 1: Demographics of aging populations and changing preferences. Different consumption basket in older age that requires deferred consumption
Economic reason 2: Rare disaster and/or protracted deflation premium
Consider a zero coupon bond
-P = e-yT
-Then if y<0,for anyT,P>1.
-The Premium p – 1 can be thought of as an insurance premium
-As time pass,the premium decays not unlike that of an option
-So basic building block, the discount factor,has an insurance interpretation to it
-You can also see what happens to a perpetuity
Peso problem:Mexican peso traded at long term discount for 20 years before the devaluation happened
Reverse Peso problem Swiss Franc trades at premium (and negative rates) structurally it’s a reverse peso problem or insurance against global financial catastrophe
“Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return from holding currency would become negative 10 percent. That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10 percent.”–Mankiw, quoting an unnamed graduate student in the NY Times, April 18, 2009
(Rare Disasters and asset Markets in the Twentieth Century, QJE, 2006.)
D/P = r – g
-If r is negative , then g has to be negative for D/P to be postive.
-Sign of future defaults?
-In the rare disaster model, falling t-bill yields are accompanied by rising equity risk premia.
Recent research (Welch 2015) suggests that index option prices can be used to explain about 2% of the 7% equity risk premium as disaster compensation
Fitting a behavioral model (Bhansali 2015) suggests that the crisis of 2008 was different in attributing a much higher subjective probability to fat tails. Compare this to 1987 where index option skew emerged mostly from
increased risk aversion
Credit: Default risk premium
Equity: Growth risk premium
Duration: Cash rebalancing premium
FX Carry: Growth, inflation differential, volatility premium
Commodity: Hedging pressures premium
Etc.
Black’s original argument:
-Observed Rate = Shadow Rate + Max[0,-Shadow Rate]
-Nominal rates = Call options on shadow rates
-Return to money market investor = Shadow Rate Return + Return on Floor
So yields = compounded(expectations + risk premia +shadow call)
So easy to mistake an upward sloping yield curve as source of risk premia rather than premium for shadow rate call
If yields are floored close to zero, the diversification properties of duration are less potent
When yields are very high, any further rise in yields usually means slowdown in economic activity and downward bias to equities, all else being equal. So this implies positive correlation to stocks and bonds returns
When yields are very low for the same reason (i.e. higher yields would mean lower growth), the same logic applies, and we may also expect correlations becoming more positive
Are assets ex-ante insurance assets or investment assets?
–For insurance assets, depending on the moneyness of the insurance, risk premium is paid, not earned.
–For investment assets, risk premium is earned as compensation for providing insurance.
Choosing individual stocks assets without any idea of what you are looking for is like running through a dynamite factory with a burning match. You may live, but you’re still an idiot.Paraphrasing Joel Greenblatt, author of The
Little Book that (still) beats the market
Investors need to evaluate the mix of insurance assets and investment assets in their portfolio according to their own exposure and tolerance to disasters.
The control of disaster risk allocation will then determine the expected return.
Carry: Selling “insurance” against rare disasters
Trend: Purchasing insurance against rare disasters
Optimal mix of long and short implicit and explicit insurance based on relative valuation
Chart shows cumulative excess returns of hypothetical monthly sales of 1M 40
-delta “real
-yield payer swaptions”, versus risk parity excess returns.
Similar return profile, 69% monthly returns correlation.
Helps characterize the risk for which this strategy earns a premium.
Negative nominal (and real) yields are a reality and might reflect changes in the economics of asset markets
They highlight the dual nature of assets: as insurance assets (return of your money), or investment assets (return on your money), under rare disasters
Portfolio construction is less about maximizing expected return per unit of risk, and more about the appropriate mix of sales and purchases of rare disaster insurance