Negative yields in European bonds are awful, but these bonds are still useful

I’ve changed my mind regarding European government bonds. Even though these bonds have negative yields and that isn’t great, I think they are still useful in a diversified portfolio. A high yield government-insured savings account can be an alternative, but it does not have some qualities unique to bonds.

Currently my standard suggestion for Fixed Income for most investors is to still use a high-yield savings account instead of government bonds. Negative yield bonds are still a relatively new phenomenon and I may be wrong. Nevertheless, this post shows how my view on European government bonds has become more nuanced and why.

How do negative yields happen?

Government bonds are typically sold at auctions. The bond buyers may end up paying more than the bond is worth if there is more demand than supply for the bonds. The demand for bonds in Europe has increased because of the European Central Bank’s Quantitative Easing policies leading to negative yields.

Let’s imagine a hypothetical country is auctioning a bond with a principal of 1 000 €, a maturity of 1-year and a coupon of 10€.
If you buy that bond for 1 000 €, you have a yield of %1 ( (1010 € – 1 000 €) / 1 000 € * 100%). You paid 1 000 €. At the end of the year you get the 1 000€ plus the coupon of 10 €. You have a profit of 10 €.
If you buy that bond for 1 100 €, you have a yield of – 8.1% ( (1010 € – 1 100 €) / 1 100 € * 100 %). You paid 1 100 €. At the end of the year you get the 1 000 € plus the coupon of 10 €. You have a loss of 90€.

To understand more about bond returns, please refer to my article on the topic.

How can these negative yield bonds still be useful?

Yields and total real returns

The yield is only an estimation of future returns. It is the best estimation we have, but the actual total return we end up observing may be different. Bonds do pay fixed coupons, but their market price may fluctuate which may create a capital gain. Our total return may be positive even though the bonds had a negative estimated yield if interest rates decrease further or because of increased market demand (e.g. due to a recession).

The Bond Fund’s effective duration can help us understand how the bond prices will change with interest changes. The iShares Core € Govt Bond UCITS ETF has an effective duration of 8.29. It means that if interest rates drop by 1%, the price of the bonds will increase by 8.29%. The inverse is also valid: if interest rates increase by 1%, the price of bonds will decrease by 8.29%.

What matters in investing are real returns (i.e. after inflation). What is better: a negative yield of -1% with an inflation rate of 0% or a positive yield of 2% with an inflation rate of 4%? The example with a positive yield has lower real returns (i.e. -2%) than the example of the negative yield (i.e. -1%). Yet, if the yield were positive, we wouldn’t be having this discussion. We tend to fixate on nominal returns instead of real returns.

What matters in investing are long-term real returns. The long-term historical real annualized return for short-term European bonds is 0.5% and 1.2% for long-term European bonds for the period 1900-2018. European government bonds are facing a crisis, and this too shall pass. It may take a while to pass, but it will pass similarly to how market declines in stocks also pass. We tend to be a bit more forgiving for stock returns than to bond returns. If your investment horizon is long (e.g. 20/30 years), the current negative yields are less concerning, since they may eventually return to normal yields.

Risk

Stocks are significantly riskier than negative yield bonds. On October 4th 2019, the iShares Core € Govt Bond ETF had a YTM of -0.10% and average maturity of 10.14 years. This means that the expected total returns of the fund (excluding fees) is -0.10% if you cash out 10.14 years from now. What are the potential returns of stocks for that period? We can’t estimate that. Stocks may be worth half their value if it gets really bad, or stocks may be worth 2% their value or stocks may be worth 120% their value. This variety of potential outcomes is risk.
If you need to keep part of your money safe, a known small loss is better than an unknown large loss.

If you have a large sum that you need to keep safe then bonds are your only choice. A bank account is only safer if insured by a government. This varies by country, but most EU countries’ bank accounts are insured up to 100 000 €. If you deposit amounts beyond the insured amount you may be in trouble if the bank goes bankrupt. If you need to preserve an amount larger than 100k € you can use multiple bank accounts but that quickly gets impractical for large amounts. It is worth also mentioning that these bank accounts are insured by the country of the bank account and not by an EU-wide scheme, so technically your bank account is as safe as your country’s creditworthiness. Folks with large sums need to rely on the safest bonds: high credit quality government bonds.

Alternatives to European Government Bonds

An alternative I suggested earlier was investing in foreign bonds through a global hedged bond fund. Hedging into Euros will make the foreign bonds have returns similar to domestic bonds in Euros. Not hedging these foreign bonds will expose you to currency risk, which is undesirable in bonds. Therefore, the only advantage of hedged foreign bonds would be to provide you with additional diversification. You can’t run away from negative yields in your currency if you hedge into it.

Another alternative I suggested was using a savings account within the government-insured amount (instead of buying bonds).
At the time of writing, in Germany there are banks offering 0.65% in effective interest rates for savings accounts with a term of 1 year, and banks offering 0.84% in effective interest rates for certificates of deposit with a term of 6 years. This looks more attractive than the bond fund with a -0.10% YTM I referred to earlier.
Bank accounts have a more predictable income since their price does not fluctuate in the market. Yet they are also susceptible to interest rate risk. If the interest rate increases, you may still be locked to your bank account with a lower interest rate. The nominal value of your bank account didn’t change but there is an opportunity cost. With Bonds you directly see the impact of interest rate changes, while with bank accounts you don’t.
Shorter term bank accounts allow you to withdraw without penalties, but longer term accounts usually don’t. Longer term accounts will have higher interest rates but more restrictions which make the opportunity cost higher.
In contrast, a bond fund will automatically adjust to new interest rates as the fund buys new bonds and sells older bonds.

Additionally, if you opt for a bank account, how do you decide that bond yields are favorable enough to get back into the market? If bond yields become negative after you have held them for many years, do you sell them? This sounds like market timing to me. I’m afraid that market timing may lead to a situation in which one is buying/selling bonds precisely at the wrong time.

Asset Allocation

Let’s say you had 60% of your portfolio in equities and 40% in fixed income. As prices fluctuate, your allocation may drift to different values than your target. Through the act of rebalancing, you bring your allocation back to your target. You may have to sell equities and buy fixed income when equities increase in value. Or you may have to sell fixed income and buy equities when fixed income increases in value. Rebalancing your portfolio will allow you to continuously sell high and buy low. If you use bonds for the fixed income, you can easily rebalance your portfolio since prices of equities and bonds fluctuate in the market. It gets harder to do this with a bank account because its prices don’t fluctuate and you may have restrictions which prevent you from quickly withdrawing/depositing to the bank account. If you don’t rebalance your portfolio, your allocation will shift to a different risk profile than what you originally intended.

Equities provide growth and Fixed Income mitigates risk. We combine these into a Portfolio that maximizes return for a particular risk profile. We should see a Portfolio as a whole instead of obsessing of the specific returns of one asset class. Equities or Fixed Income may go through periods of low returns but the whole Portfolio has reasonable returns for the current economic environment.

Therefore, I think the easiest is to pick an asset allocation based on your investment horizon and risk profile and stick with it. There will be momentary issues with both asset classes, but over the long term the total portfolio will have positive real returns.

Summary

Investing in funds with European government bonds for the long-term is still reasonable despite their negative yields.
Given the long time horizon, these bonds will eventually have better yields.
Even in the event of negative yields, positive total returns can still be observed because of price fluctuations.
Bonds allow you to mitigate risk in a way that stocks can’t.
Bonds are more flexible than savings accounts. Bonds are the only option for investors which large sums beyond the government-insured amounts.
Bonds can be easily rebalanced in a portfolio.
The returns of the whole portfolio over the long-run are what matters instead of returns of specific asset classes.
I still suggest that most investors use savings accounts instead of bonds when it comes to Fixed Income.