As a kid I read a few DC comics that were set in the Bizarro world of “htraE” (or “Earth” spelt backwards). It was a world where everything is essentially inverted or the opposite of expectations. In fact, one episode depicts a salesman selling Bizzarro bonds that were “guaranteed to lose money”. Ironically, this is not a comic book story anymore. Bizarro world is now part of our current financial markets.

Bizarro Bond Market

Until last week, no country in history has ever sold ten-year debt that offered investors a NEGATIVE yield. Switzerland actually issued a bond for ten years that investors are PAYING to hold. You read that correctly. If you bought this issue you were essential guaranteed to lose money over ten years if you held it to maturity. Crazy; but this is just the beginning. In the major bond markets of the world, there are now seven countries that have NEGATIVE or essentially zero two-year rates on sovereign bonds (see Table 1).

In fact, five countries (France, Germany, Sweden, Netherlands and Switzerland) have negative yields all the way out to five years! In nominal terms, at least, you are paying these governments to hold your money! The European Central Bank has even begun charging commercial banks to keep money on deposit. Anchor’s GDP-weighted G10 government bond index recently has hit a new all-time low of 1.1 per cent. Even Nestle, the Swiss confectionery company, issued “free money” with a recent bond issue with a negative yield!

Why have we gone crazy

To summarise a few reasons for the Bizarro bond world:

1. Supply and demand imbalance: From a global perspective, not less than 20 central banks cut their benchmark target rates and a few announced new quantitative easing programmes. The European Central Bank (ECB) was the most prominent one with its intention to increase its balance sheet by 1.1 trillion euros by September 2016. Quantitative easing programs by the European, Japanese and Swedish central banks have outpaced past asset purchases by the Federal Reserve (Fed) on an equivalent basis. While the U. S. programme was successful in lifting inflation expectations, which led to rising long-term government bond yields, today’s programmes have had the opposite effect so far. Asset purchases have led to a scarcity of available bonds, driving an estimated notional value of $3.6 trillion towards negative yields. A study by the Bank Credit Analyst indicated that net new sovereign bond supply from the US, Eurozone and Japan will be negative this year and the next. However, this estimate does not incorporate the rising likelihood that the Bank of Japan may step up its asset purchase programme even further. Furthermore, new regulations on risk-weighting such as Basel III and Solvency 2 further pressure demand for risk-free weighted assets. A lack of supply and increasing demand for the safest of fixed income securities have anchored bond yields at unprecedented low (and in some cases negative) rates!

2. Savings glut: The global savings glut has led to continued inflows into fixed-income securities. A study by the International Monetary Fund (IMF) calculates global savings as percentage of GDP at 25 per cent (a record high) and it is expected to increase by another 1.5 per cent over the coming five years.

3. Deflation: Inflation expectations have receded dramatically and realised inflation has turned negative in some economies. The plunge in oil prices has had a major effect on consumer prices but also the core index has decreased. That is why the major central banks have failed their inflation mandates for five-plus years. While cash yielding nothing may seem taxing, investors will buy bonds with negative yield if markets are expecting deflation. If you believe that you will see 1 per cent deflation and you pay 0.5 per cent to a bank to hold your money, in real terms, you can come out ahead by 0.5 per cent.

4. Rising debt burden: Lastly, the high and rising global debt burdens have become a structural impediment for higher economic growth and inflation rates. Like we have noted many times before, debt is simply a temporal shift in spending. Higher debt now essentially is a form of stealing spending from tomorrow. A study by McKinsey shows the global stock of debt outstanding has risen from $142 trillion at the end of 2007 to $199 trillion in the second quarter of 2014. This 40 per cent rise has far outpaced the increase in global GDP of 32 per cent and consequently has led to a further increase in the debt-to-GDP ratio, which has encouraged more saving and less consumption.

5. Risk aversion: It also makes sense if you are extremely risk averse to the point that they are willing to pay a ”security fee” for the perceived safety of these assets. Investors under this assumption worry that other alternatives could collapse in price and see other options as riskier.

6. Speculation and trading: Traders may also be buying these bonds under the expectation that yields will actually go lower so that they can profit by selling them later at a higher price. They may also be buying negative bonds under the theory that the negative yield could be more than made up for by currency gains.

Implications of a Bizarro World

There are numerous implications that arise with this Bizarro financial situation and here are just a few:

1. Bubbles — The hunt for yield and free money will surely result in bubbles developing in various areas of the financial market. Investors hunting for some return, no matter how small in comparison to guaranteed losses, could be tempted to reach farther and farther into riskier classes of assets and thus elevate prices to levels fundamentally unsound. Bubbles in various equity markets and real estate could develop.

2. Dollar rally — With the US Federal Reserve contemplating tightening of monetary policy and raising rates while other nations such as Europe and Japan continue to embark on aggressive monetary easing, the US dollar actually looks relatively attractive. In fact, the current ten-year US yield of about 1.9 per cent is the third highest yielder among the developed world! The attractive interest rate differential and the prospects of even higher rates could give the US dollar a further boost even after its recent surge.

3. Impossible math? — Have you ever tried to discount a cash flow or earnings stream by a negative number? The math really doesn’t work. If I gave you free money you technically should take as much as you possibly can, especially if I paid you to take it! This obviously goes against some basic fundamentals of finance like the time value of money. If you discount something by a very low number it actually increases its value. If you discount it by a negative number it looks negative but could technically be worth infinite in value. This throws many financial models and return calculations upside down and makes analysis more challenging.

Bizarro world is here and investors will need to learn to navigate its twists and turns. If the next recession were to arrive tomorrow, where would rates go from here?

Nathan Kowalski CPA, CA, CFA, CIM is the chief financial officer of Anchor Investment Management Ltd and can be reached at nkowalski@anchor.bm.

Disclaimer: This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by the author to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. Readers should consult their financial advisers prior to any investment decision. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.