How does it work when yields go down

Falling yields, rising prices - will the bond boom be a trap?

NEW ISENBURG. Because the global economy is losing momentum as a result of the trade conflicts fueled by US President Donald Trump, investors are turning away from stocks and instead investing in bonds. That depresses their interest.

Experts see this critically, because corporations could use the increasingly cheaper bonds to borrow more. The Bank for International Settlements (BIS), for example, warns that in the USA the volume of potentially defaulted loans has risen to more than 3,000 billion euros. "The low interest rates favor the build-up of debt," says BIS Director General Agustín Carstens.

High inflow bonds

According to the investment statistics of the index fund provider Amundi, private and professional investors withdrew a balance of EUR 11.7 billion from listed index funds, so-called ETFs (exchange-traded funds), which invest in stocks between the beginning of January and the end of August. To do this, they invested 33.4 billion euros in index funds during this period, which invest in corporate and government bonds.

“Bonds have been the ETF asset class with the highest inflows in Europe since the beginning of the year because of investors' continued search for returns,” says Fannie Wurtz, Head of Amundi ETF.

For those investors who invested in bond ETFs earlier this year, the commitment has paid off. Individual ETFs, such as the iBoxx EUR Liquid Sovereign Diversified 25+ from the index fund provider Comstage, which invests in long-term government bonds, have increased by more than 30 percent since the beginning of January. Bonds are debt securities that can be traded every trading day. Companies and governments use them to borrow money on the capital market.

Interest brings a paradox of returns

In return, the investors receive a pre-determined interest payment over the entire term each year. This makes the papers the preferred investment in weak economic phases. Because companies then cut their dividends because they earn less.

The fixed interest payment creates the so-called return paradox with bonds: if the price of a bond on the stock exchange rises, the return that can be achieved by buyers falls.

This is made clear by a calculation example: If the fixed annual interest payment for the issue of a bond with share certificates worth 10,000 euros is 200 euros, the investors achieve a return of two percent per paper. If the value of the share increases to 11,000 euros, the buyer still receives 200 euros per year. Measured against the now higher cost price of 11,000 euros, however, its return is only 1.82 percent.

Bonds are divided into shares with a value between 10,000 and 50,000 euros. Most private investors therefore do not invest in individual bonds, but in bond funds. These bundle the capital of many investors and spread it over numerous bonds selected by the fund management.

However, these actively managed funds incur annual fees of up to 1.5 percent. In addition, there are front-end loads of up to 3.5 percent, which flow to the intermediary banks when the fund units are purchased.

This is different with bond ETFs. They passively track an index of government or corporate bonds. The annual fees are therefore only 0.05 percent in some cases. In addition, there are no front-end loads, as ETF shares can only be purchased on the stock exchange.

Experts with worries

Since the beginning of the year, private and professional investors have increasingly invested in bonds because the global economy is becoming increasingly gloomy. The urge for bonds is also being spurred on by the recent interest rate cuts by the US Federal Reserve and the announcement by the European Central Bank (ECB) that it will purchase bonds worth 20 billion euros every month from November to stimulate the economy.

As a result, the yields on bonds have continued to shrink. German government bonds with a ten-year term currently show a negative return of minus 0.5 percent. Investors pay money to be able to lend their capital to the state.

It is not just many investment experts who are concerned about this development. If the interest rates on bonds rise again at some point, some companies could have problems refinancing their bonds, which are now issued at mini interest, says Manfred Rath, portfolio manager at KSK Vermögensverwaltung in Nuremberg.

Investors who bet on bonds would therefore have to trust the ECB. "If the European Central Bank did not keep the yields artificially low," says Rath, "companies would have to offer significantly higher interest rates" in order to find buyers for their bonds.