The yield on 10 year German government bonds hit a record low of minus 0.317% following a speech from European Central Bank president Mario Draghi on Tuesday, in which he said that further cuts in policy interest rates and a relaunch of the asset purchase programme were both still possibilities in Europe.
It was a similar if less dramatic story in the US later in the week, with the 10 year US Treasury yield falling to below 2% for the first time since November 2016 after Federal Reserve chair Jerome Powell said that the case for cutting interest rates had improved amid economic uncertainty.
The new market moves are likely to have a profound impact on execution in the primary debt markets, as more and more important pricing reference points dip below 0%.
FIG DCM officials said this week that the prospect of banks pricing new covered bonds at negative yields was now back on the table.
Berlin Hyp became the first bank to sell a new covered bond at a negative yield in the euro market back in March 2016, when it raised €500m of funding at minus 0.162%.
It then repeated its feat in November 2017, pricing another €500m deal to yield minus 0.108%.
But there has been little in the way of follow-ups over the last couple of years.
“The real question now is when again we will price a Pfandbrief in negative territory, with the clear intention to do so from the outset,” said one head of FIG syndicate.
“Five, six or even seven year covered bonds from core issuers should all be pricing in negative territory, taking into account where secondary market valuations are and the prospect of new quantitative easing from the ECB.”
No yield, no cry
In recent weeks, covered bond issuers have been pushed into selling longer dated bonds in a bid to offer positive yields to investors.
For instance, a banker involved in Aareal Bank’s €500m 0.01% eight year covered bond last week said that the firm would rather have gone for a five year deal, given that a shorter dated offering would have better matched the assets in its cover pool — mostly commercial real estate loans.
“The issuer thought it might be a bit early to test the water for negative yields, so they went for eight years,” the banker said.
The banker agreed with Aareal’s assessment but said that he would not “rule out” the possibility that issuers would consider negative yielding new issues, given that investors would still be getting “a considerable pick-up to German Bunds” after this week’s moves in government bonds.
He pointed towards Berlin Hyp and MuHyp as potential candidates, because they both have a “natural preference for shorter maturities”.
The first banker admitted that arrangers were still a little “scared” of testing appetite for short dated covered bonds from core European issuers, because of the risk that there is not enough demand from investors for a deal with a negative yield.
But the banker said that “if one or two issuers go for negative yields then it could become the norm” in the market.
Only about 15% of the stock of outstanding Pfandbriefe is trading with a positive yield, he noted.
How low can you go?
There could also be negative yielding issues in the corporate bond world. This has happened before — in March, for example, Sanofi, the French pharmaceuticals group that is a particularly price-sensitive issuer, sold an €850m three year bond that was priced, in a very hot market, 5bp-6bp through its own curve at 5bp over mid-swaps, resulting in a yield of minus 0.05%.
“If risk-free rates stay where they are, we have to assume you will end up with more negative yielding credit,” said a bond portfolio manager in London. “For example, the five year Bund rate is about minus 0.6%, and there are a lot of issuers that trade with credit spreads tighter than 60bp.”
This hardly puts investors in a comfortable position, but he said: “The alternative is you put cash on deposit and that’s just so expensive.”
His firm had bought corporate bonds at negative yields before, since the return was less negative than cash. “At least you are not paying minus 0.7% or 0.8%, you’re only paying minus 0.1%. It’s about capital preservation. What are the other alternatives? You go to something extremely risky, but then you have the risk you don’t get your money back.”
However, for a company, being able theoretically to issue at a negative yield, based on its secondary curve, does not necessarily make it practically feasible or wise.
“Absolutely it is a possibility, but there’s a limit to how negative you can go,” said a syndicate banker in London. “Some of the low beta issuers will just be forced to issue at more intermediate and longer parts of the curve, rather than doing short-dated bonds.”
Since investors might not want to buy at negative yields, issuers would either have to pay a higher than normal spread to issue at them, or avoid that by going longer. “The other option of course is to do a floating rate note,” the banker added.
He predicted that single-A rated issuers would mainly move to longer maturities.
Working out how many investors would refuse to buy bonds at negative yields was tricky, he thought. However, he said “in the secondary market there are a huge number of outstanding bonds that have negative yields. Investors are buying and selling in these conditions. It’s very hard to put an exact number on it, but a significant number of investors will buy at slightly negative yields, but when you go beyond 5bp there are very few that will buy.”
That may mean the floor is the -0.05% Sanofi achieved — for the time being.
Increasingly, market participants appear resigned to the idea that Europe is stuck on a course of low economic growth, low inflation and loose monetary policy — a phenomenon commonly referred to as Japanification.
Signs this week that ECB could be ready to turn its QE programme back on after having just switched it off will only fan those expectations further.
“It’s such a change of tack,” said one analyst, “it will be here for a while. So will negative yields. The longer it’s here, the more we will see names you wouldn’t usually consider negative rates names to go negative and stay there.”
As well as pushing German bond yields to record lows, Draghi’s speech this week also sent France’s 10 year debt slipping into negative territory for the first time ever, while Austrian 10 year government debt dipped into negative territory too.
France’s 10 year debt has since moved back into positive territory, but the analyst said they “would not be surprised” if 10 year French debt went negative again if the ECB’s implementation of its easing policy was as dovish as Draghi hinted.
Speaking at an ECB forum in Portugal on Tuesday, Draghi said: “If the crisis has shown anything, it is that we will use all the flexibility within our mandate to fulfil our mandate — and we will do so again to answer any challenges to price stability in the future.”
The ECB’s asset purchase programme still has “considerable headroom”, he added, noting that “further cuts in policy interest rates and mitigating measures to contain any side effects remain part of our tools”.
The “speech marks a remarkable U-turn for global central banks”, said ING analysts, “But only time will tell if this unprecedented activism was genuinely ahead of the curve or just sheer panic”.
Mario Draghi’s intervention provided the backdrop to the Euromoney Global Borrowers and Bond Investors Forum this week, where delegates engaged in discussions about how central bank policy is likely to evolve.
“The probability of action has increased sharply, and the question is now not if they are going to do something but what they are going to do,” said Vincent Chaigneau, head of research and group investment strategy at Generali Investments, on a panel about QE.
“If they start PSPP [the public sector purchase programme], the most likely way for them to do that is increase the issue limit from 33% to say 50%. What they could say is for high rated countries they could increase issuer limits to 50%, while we keep others at 33%.”
On the same panel, David Zahn, head of European fixed income at Franklin Templeton Investment Management, focused on the possibility that the ECB would look to help banks out by introducing tiered rates of deposit — something that is increasingly being seen in the market as a likely outcome.
“Tiering would suggest that we are going to be at this new rate level for many years,” said Zahn. “You don’t do the tiering for only six or 12 months, you’re saying we will be down at these levels for many years.”