For The First Time Ever, Real US Investment Grade Yields Turn Negative
In late December, in our recap of a “year like no other” for credit markets, we showed a stunning chart which perhaps best summarized the “insanity unleashed by central banks.” The chart in question showed that a record-high number of European IG (investment grade) bonds were trading with negative yields. To wit, as of December 15, 41% of the EUR IG iBoxx index yields in sub-zero territory; a level that matches the previous record in August 2019.
Even more impressive: more than 10% of the index now yields below -0.25%, and as Goldman concluded, “negative yields are likely remain a fixture of the EUR IG corporate bond market in 2021, even if bund bond yields back up in response to solid growth next year. Combined with the decent demand tailwind from ECB purchases, this would keep search for yield motives strong.”
Fast forward a few weeks, when it’s not just the EU where the corporate bond market is trading at absurd levels.
As Goldman’s credit strategist Michael Puempel writes, in early December, real yields on USD IG corporate bonds turned negative for the first time in history, against a backdrop of all-time high duration.
As Goldman elaborates, the relentless march lower of real yields to negative territory “reflects the combined effects of the material decline in nominal corporate bond yields and the back-up in inflation expectations.” The next chart shows how widespread negative real yielding corporate debt in the USD market is, with more than 25% of issues, representing more than 30%of index-eligible par value, priced with a real yield below -0.5%.
This means that a large portion of IG-rated corporations are expected to be paid, on an inflation-adjusted basis, to borrow in the USD market today, according to Goldman. And although all-time high duration comes with its own risks, negative real yields will likely skew incentives for corporate issuers – encouraging them to issue even more debt – while at the same time mechanically increase risks for investors.
A quick look at these two key factors starting with…
Skewed incentives for issuers
There is always competing interests between equity- and debt-holders when it comes to corporate issuance and the uses thereof. This tension will be exacerbated for corporates that can issue at very low, i.e. negative, real yields. Specifically, the lower the yield at which a corporation can issue debt, the higher the incentives are to return capital to shareholders, via either debt-funded M&A or share repurchases (or, more recently, by purchasing bitcoin). Meanwhile, Goldman forecasts that negative real yields for such a large portion of the IG universe has elevated the risk that “the significant increase in gross balance sheet leverage, which was meant to be a temporary response to the sudden stop in the economy, ends up being permanent.”
Elevated risks for investors
The risks for investors in this environment, as it relates to negative real yields is two-fold:
First, and the most acute, is that investor returns are now very susceptible to even the slightest unexpected uptick in the inflation. While traded breakeven inflation is not a perfect proxy for expected inflation, as it embeds a risk premium, positive real yields have historically provided, at least to some degree, a cushion with respect to an unexpected inflation shock. This is no longer the case, because even if realized inflation falls below market expectations, it may not be enough to push ex-post real yields back into positive territory given current levels.
The second risk for investors is related to the second-order effect of low yields; re-leveraging risk. That is, if firms take the “opportunity” presented by yields at historic lows to increase the size of their capital structures even further, this could in Goldman’s words, “manifest itself in heightened fallen angel/downgrade risk under a scenario in which the earnings recovery of highly levered issuers do not rebound at a pace commensurate with expectations.”
While these risks should be manageable in the near-term given improving growth expectations for 2021 on the back of massive stimulus, as the economy reverts back to full-capacity, Goldman concludes that “it will be crucial for both corporate bond issuers and investors to shift their decision-making frameworks to account for real, as opposed to nominal, outcomes.”
Sun, 01/10/2021 – 19:10