How to Make Sense of Inverted Yield Curves and Negative Yielding Debt?
If you have been watching the news over the last few weeks, you are likely to have seen headlines relating to the $17 Trillion negative yielding debt, the inverted yield curve and a looming recession. I have. And perhaps like me, some of you might have wondered what all of this really means and what you need to be doing differently. I.e. so what?
So this week when someone suggested that I write about it to help simplify this for my readers, I thought, why not? But before I begin, I do want to put out my disclaimer that I am not a financial advisor/journalist so take this as a friend chatting to you in the pub trying to explain how it works. Going with that theme, I’ve chunked our chat into a few key questions such as ‘what’s going on?’ and ‘what should I be doing?’
‘What’s going on? What does a Bond even mean?’
Great question. Imagine I borrow money from you. I assume you may want some interest & some proof.
Ok. So let’s assume that you loan me £100 at 10% interest for 20 years. This means that I need to pay you £10 each year and then the full amount of £100 after 20 years. That takes care of the interest. The proof, the IOU (I Owe You), which confirms this, is a bond.
Now if it is the government that is the one borrowing, then that bond is a government bond because that is you loaning money to the government. For you, this is a safe way to store your money while earning some interest and in the meanwhile, the government can use the money to look after the economy. Similar story for corporate bonds which is when you loan your money to a company.
Now historically, there are two key things that come into play.
If you loan me money, you expect to get back all your money and some interest for taking on risk
The longer you part with your money, the more you expect to get back. This is because you take more risk and then the real value of that amount money is expected to decrease over time. For example, if I was to return the money to you in 30 years instead of 20 years, you might want 15% interest instead of 10%.
‘Got it. So what’s this bit about the $17 Trillion negative yielding debt?’
Given the low and negative interest rate environment that we live in, it may be that the debt can give you negative outcome. And this is where traditional believes start to go topsy turvy.
In this situation, the narrative changes completely. Looking at life from this lens, it is not me borrowing money from you but you paying me to look after your money for you and if you wait for the full 20 years, you will actually receive less than you gave me at the start.
Now the concept is driven by sub-zero interest rates and is not new but what is new is the amount of money that is sitting in this negative yield bucket. It is believed that this bucket carries over a quarter of all the debt issued by companies and governments.
So while the bucket has been around for a while, it’s the amount in the bucket that is making headlines.
‘And what’s the news inverted yield curve then?’
I think this scenario is slightly better than the above scenario because here, you still get back more than you put in however in this situation, if you loan me money for a longer time, I will actually give you a lower interest rate.
Now if you see this from a traditional lens that you are loaning me the money, then this is odd because the longer you loan the money, the more you want to be compensated. After all, you are taking more risk and the time value of money will mean that you want more in return.
But if you come with me to this topsy-turvy land where you are paying me to look after your money, then this feels logical because the longer I work on protecting your money for you, the lesser you get. Suddenly, it begins to feel fair.
‘Why is this happening?’
Well for starters, it’s a low/sub-zero interest rate environment and the bond rates follow central banks’ interest rates. As I said the bucket has existed for a while now but when the the FED cut interest rates in Aug 2019, that tipped the numbers and made headlines.
But one key thing that we are reminded is that a lot of this money is money that is given by the central banks by way of quantitative easing to inject liquidity into the economy and therefore, not all of this is market money.
‘So what do I need to do?’
Some news suggests that the above signals an oncoming global recession. Depending on where you look, you will find cases for and against and I won’t go into the detail here. I suppose these may be some things you might like to consider.
Stay Informed: As you make investment choices for your hard earned money, it is good to understand where the global economy is going. Regardless of how much you own and where it sits, it is good to have a basic understanding.
“It’s like getting a basic understanding of food even though you might have left the selection to the chef.”
Respect Risk: If you do make your own investment decisions, then you may want to recognise the increased risk sentiment even if you don’t buy bonds. Only you can decide what is best for you.
No one can predict a recession with a 100% accuracy and what you do will depend on your personal situation and mindset. But here below are some responses I can sense.
Analysing and Planning: There are some who are focussed on the heightened negative sentiment. They are primarily analysing the likelihood of a recession and acting accordingly. The fears of a looming recession, compounded by the fears of a no deal Brexit, might be a worrying case for some.
Seeing the Bigger Picture: Some people are less worried and continue to remind us that a large chunk of longer-term government bonds are held by the central bank and the figures reflect quantitative easing beside market holdings.
Looking for Opportunities: There could be some who are seeking to profit from the negative yielding debt e.g. they could buy and hold the negative yielding bond in the hope that if interest rates drop even more, then what they have in hand will become relatively more valuable over time. Then there are others, who see the simultaneous sell off in stocks as a great opportunity to buy stocks instead. Such people are thinking of events such as the 2020 US elections and perhaps expecting that the president might want to showcase a great economy. The US consumer and earnings are still believed to be strong. There seem to be a lot of opportunities for those willing to explore.
Sticking to the Principles: As for me, I invest as principle and while I watch the news, I stick to my long-term philosophy for single stocks. For me, the news is like like checking the weather app before going for the run. I do my best to run anyway.
And with that, I need to head for my run. But before I go, I would love to have some feedback on whether this article was helpful in clarifying some concepts and showcasing some mindsets that people carry. If it helped to shift your mindset in anyway, then I would love to hear that too. Even Buffet, who stayed away from the tech-sector has recently shifted his mindset to up his stake in Amazon to 11% (now $1 Billion).
The ultimate aim is to adopt the mindset that serves us best. I look forward to hearing your thoughts.
I am a keynote speaker and a mindset coach. You can reach out to me for bookings via my website vinitaramtri.com or drop me a note on +447817256077.