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  12 | INVESTMENT EXECUTIVE NEWS Negative-yield junk is here
March 2020
   Investors accept default risk on bonds that pay less than nothing
rating from Standard & Poor’s Financial Services LLC, saw its 2021 euro bond drop in 2019 to yield about zero — negative after trade cost.
These unfamiliar names have added to the estimated US$15 trillion of euro-denominated bonds with negative yields. None of these bonds were issued with negative yields, but investor demand for anything that pays more than negative-pay sover- eign bonds raised corporate bonds’ prices, resulting in effect- ively negative yields.
As of July 2019, 14 compan- ies were trading with nega- tive yields, with those bonds worth more than €3 billion ($4.3 billion). In all, about 2% of European high-yield bonds car- ried negative yields.
In some cases, a respectable bond with a good yield is priced so high that its coupon generates a negative return. For example, Colorado-based packaging com- pany Ball Corp. has a euro- denominated issue maturing in Dec. 2020 that traded at –0.2% in July 2019. That yield beats the euro deposit rate of 0.7% on a German government bond with the same maturity at the same time.
Buying a negative-pay bond that will leave the holder with less than the issue price and
once upon a time, bonds
were a way to invest, get decent returns and get your money back. Then came junk bonds, then negative-pay government bonds and now negative-pay junk.
The recent innovation was perhaps inevitable in the quest for enhanced yield. Wags are calling negative-pay junk “peak greed” — a sign of the desper- ation to get some yield even if it’s not much and there’s a good chance of default.
More than one-third of European investment-grade debt is negative-pay, according to New York-based Tradeweb Markets Inc., and that is driving the fixed-income market toward higher-yielding junk bonds.
Switzerland, Germany, the Netherlands, Denmark, Sweden, France, Ireland, Spain, Portugal and Italy have issued negative-pay bonds. (The list excludes Greece, which the fixed-income market believes is unable to raise enough money through taxes to repay its national debt.) As of Dec. 31, 2019,
Switzerland gets the lowest rates: from –0.84% for three months to –0.34% for 20 years. Italy, mean- while, offers –0.27% for three months and –0.01% for two years.
Scrimmaging to tempt inves- tors with return of some kind, junk issuers have sold debt that doesn’t pay money; rather, it pays more junk. This pay-in-kind debt — the lowest level of “eurodebt” — gives the issuer the option to pay inter- est due with even more debt. That option, called a “toggle,” is not new, but it’s back in fashion after tryouts leading up to the 2008-09 global financial crisis.
Bonds that pay little interest, negative interest or no money at all are symptomatic of the his- torically low interest rates pre- vailing in major markets. In this climate, a small number of non-investment-grade compan- ies have issued negative-pay, euro-denominated bonds. One such company is Ireland-based packaging company Smurfit Kappa Acquisitions ULC. Smurfit Kappa, with a speculative BB+
then expose the holder to sizable default risk seems irrational. But there is a rationale. First, nega- tive yields can be seen as storage costs. You buy a freezer and pay the power bill to store ice cream, so why not pay to store cash?
However, the freezer will not eat your ice cream, so this theory is not the whole story.
The more technical explan- ation is that duration — the weighted value of a bond’s cash return plus the return of the issue price, divided by the present interest rate — has been increasing for investment-grade bonds. The higher the duration, the higher the bond’s responsive- ness to interest rate changes.
Since the end of 2018, the aver- age investment-grade bond dur- ation has climbed by 13% to 8.02 years, thus increasing the risk of holding what may be regarded as bonds with a good pedigree, as noted in the Wall Street Journal onJan27.
For junk bonds, durations as
well as terms have been drop- ping. That is compensation for the presumptive idiocy of buy- ing negative-pay junk that can top a money-losing return with a potential collapse of capital value. The average specula- tive-grade bond duration has dropped by 24% to three years over the past six months.
Moreover, a recent report from North Carolina-based Bank of America Corp. noted that the gap in yields between the bottom level of investment-grade and the top level of investment-grade is narrow by historical standards and even less when adjusted for changes in duration.
In spite of what may appear to be a freak show of bonds that pay little and carry hefty default risk, junk has been profitable.
To illustrate: BlackRock European High Yield Bond Fund generated a 9.72% total return for the 12 months ended Jan. 31, 2020 — 44 basis points ahead of its benchmark. IE
    “We look for stable, growing businesses with strong balance sheets”
Moody’s Investors Service, has
a stranglehold on bond rating in the U.S. S&P also provides data, analytics and a large numbers of equities indices. Its stock price rose by 61.3% in 2019.
■● invesco canada ltd. Mikalachki says one of the invest- ment team’s most successful stock picks in 2019 was Brookfield Asset Management Inc. The company had an exceptional year, with AUM increasing by 42% and the stock price shooting up by 52.4%. Another winner was Germany- based Scout24 AG, the dominant operator of online automotive and real estate marketplaces in Germany and certain other European countries. Scout24’s stock price rose by 42% in 2019.
Invesco’s stock-picking is
complemented by a similar approach on the fixed-income side. The fixed-income team in Canada uses information gath- ered from the global network of the firm’s Atlanta-based parent to look for high-quality bonds worldwide, explains Avi Hooper, senior portfolio manager, global investment-grade team, fixed-in- come. Most holdings are invest- ment-grade corporate bonds, but there are some emerging-market sovereigns denominated in U.S. dollars or euros, such as BBB- rated Kazakhstan’s and AA-rated Qatar’s government bonds.
■● rbc global asset man­ agement inc. “All in all, 2019 was a great year for balanced funds because almost all asset classes delivered solid gains,” says Dan Chornous, CIO of RBCGAM. He is cautious about
2020, though. Interest rates are unlikely to go lower and earnings expectations are moderate. “Given the aging business cycle and a var- iety of durable macro risks,” he adds, “we are reluctant to take on significant risk in our portfolios.” ■● investors group inc. This fund family has struggled over the past three years, but John Kilfoyle, senior vice president, IG Investments, attributes this mainly to higher-than-average fees. The company is aggressively addressing the issue by mov- ing AUM into low-fee “U” (a.k.a. unbundled) funds. Because the firm has a captive sales force, this transition can be made quickly. Kilfoyle expects 80% of AUM to be held in “U” funds by the end of this year. He says this will signifi- cantly increase the fund family’s performance figures.
■● franklin templeton investments corp. Duane Green, Templeton’s president and CEO, notes that although the fund family’s performance remains below average, it has been improv- ing — to 34.6% of AUM in the first or second quartiles in 2019 from 34% in 2018 and 25.7% in 2017. Green attributes that improve- ment to the company’s efforts to diversify by introducing new funds with different strategies.
Although the newer funds are small, many are performing well and Green expects them to push up the overall performance num- bers as they attract more assets. ■● beutel goodman & co. ltd. Although the company had a relatively weak year in 2019, its longer-term record is stel- lar, with an average of 75.7% of long-term AUM in above-average
performing funds in 2014-18 vs only 9.4% last year.
Beutel’s portfolio managers are long-term investors who don’t worry about short-term swings, says Black: “We look for stable, growing businesses with strong balance sheets [and] trading at discounts to their intrinsic value. If the market goes up, we monitor that everything we own remains well priced, and harvest gains where our process demands.”
Black adds that his firm’s pro- cess targets the most appeal- ingly priced businesses, keeping long-term return expectations attractive. “If the market goes down,” he says, “we will seek to take advantage by buying more of the businesses we own and have high conviction in, or [by] taking new positions that were previously too expensive.” IE
To tempt investors with return of some kind, junk issuers have sold debt that doesn’t pay money; rather, it pays more junk
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