(Bloomberg) — In the negative-yield vortex that is the European bond market, investors are discovering just what lengths theyre willing to go to generate returns.
Norways $870 billion sovereign wealth fund said this month that it added Nigeria and lifted its share of lower-rated company debt to the highest since at least 2006. Allianz SE, Europes biggest insurer, is shifting from German bunds to bulk up on mortgages. JPMorgan Asset Management is buying speculative-grade corporate debt to boost returns.
With the European Central Banks fight against deflation pushing yields on almost a third of the euro areas $6.26 trillion of government bonds below zero, even the most risk- averse investors are taking chances on assets and regions that few would have considered just months ago. Thats exposing more clients to the inevitable trade-off that comes with the lure of higher returns: the likelihood of deeper losses.
We are wandering into uncharted territory thats subject to uncertainty and mistakes, said Erik Weisman, a Boston-based money manager at MFS Investment Management, which oversees $430 billion globally. Hes buying debt with longer maturities and increasing his allocation of top-quality government holdings to Australia and New Zealand, which have some of the highest yields in the developed world.
The shift is a consequence of how topsy-turvy the bond market has become as falling consumer prices and stubbornly high unemployment prompted the ECB to step up its quantitative easing with government debt purchases.
Sub-Zero
About 1.44 trillion euros sovereign debt, valued at about $1.9 trillion as of their issue dates, from Germany to Finland and even Slovakia, carry negative yields.
That means the bonds guarantee losses for buyers who hold them to maturity. In effect, investors are betting the securities will appreciate in price before then, allowing them to sell at a profit before they come due.
On average, the 19 countries that use the common currency can effectively borrow euros for almost a decade and pay about 0.5 percent in interest, index data compiled by Bloomberg show.
The perils of going into riskier debt were demonstrated when Austria removed its support for state-owned Heta Asset Resolution AG, undermining confidence in the 1.3 trillion-euro market for state-guaranteed debt that was once deemed risk-free.
Norges Bank Investment Management, the worlds largest sovereign wealth fund, increased corporate bonds rated BBB or lower to 8.3 percent of its debt assets at the end of last year from 7.5 percent in the prior quarter, the fund said March 13.
No Upside
Among those assets are about $200 million of bonds issued by Petroleo Brasiliero SA. Brazils state-controlled oil company, the biggest corporate debt issuer in emerging markets, has seen its benchmark 2024 bonds tumble almost 10 percent since allegations of kickbacks and bribes emerged in November.
The fund also added developing countries such as Ghana and Mauritius and invested in Nigerias currency for the first time. It may invest a lot in Asian properties, said Karsten Kallevig, head of real estate investments at the Oslo-based fund. Just 0.1 percent of the fund is invested in top-rated corporate bonds.
Andreas Gruber, the chief investment officer of Allianzs money-management unit, says his firm favors commercial-mortgage loans, infrastructure debt and emerging markets.
Buying negative yield, on the long-term, you only have downside but you never have upside, Gruber, who oversees 615 billion euros, said by telephone from Munich.
Global Opportunities
Before the credit crisis, bond investors could get yields closer to five percent from debt issued by Italy and Portugal, versus 10-year rates of 1.22 percent, and 1.64 percent, respectively, at 10:31 a.m. London time.
Now, monetary easing by more than two dozen central banks around the world, from those in Japan to Switzerland to China, means some investors are going further afield such as Indonesia to get the similar returns.
Iain Stealey, a fixed-income manager at JPMorgan Asset Management, which oversees $1.7 trillion, is doing just that. He says low borrowing costs and subdued inflation will support junk-rated corporate debt, which yields 3.6 percent in Europe.
When you are paying some governments to own their bonds, 4 percent actually looks very decent, Stealey, who declined to comment on specific fund holdings, said from London.
His Global Bond Opportunities Fund, which isnt constrained by benchmarks, has about 75 percent its assets in speculative- grade or unrated debt securities, according to data compiled by Bloomberg. They include Kazakhstans KazMunayGas National Co., filing data compiled by Bloomberg show. The fund also owns Indonesias 9 percent local-currency bonds due in 2029 and Brazils 4.25 percent debt due in 2025, the data show.
Bond Support
European enthusiasm for higher-yielding assets has helped U.S. borrowers sell 3.28 billion euros of junk bonds in 2015, the busiest start to a year since the currency started in 1999.
In the month after the ECB announced that it would start buying government bonds, flows into the regions high-yield corporate bond funds surged to the highest in a year, according to the Bank for International Settlements.
Deutsche Asset & Wealth Managements Stefan Kreuzkamp says that while ECBs stimulus and negative deposit rate are sapping liquidity and making it more costly for money managers to hold cash, hes not about to load up on emerging-market or junk bonds to enhance returns because the central banks bond buying will keep boosting prices.
Euro-area sovereign bonds have returned 4.4 percent in the first three months of the year and are poised for the biggest quarterly gain since 2008, according to index data compiled by Bank of America Corp.
The decline in yields isnt bad news for investors and it means further capital gains, said Kreuzkamp, the Frankfurt- based firms chief investment officer for Europe.
Unpleasant Fashion
The insatiable demand for higher-yielding assets from lower-rated issuers is leaving investors prone to sudden losses.
For MFSs Weisman, the fact that yields for bonds of all types, from the most-creditworthy to the riskiest, are so historically low means that when the selloff finally does happen, it has the potential to be nasty.
Take Germanys 16 billion euros of bonds due 2044, which the MFS Strategic Income Fund held at the end of last year, data compiled by Bloomberg show. If yields, currently at 0.59 percent, rose a half-percentage point in the coming year, buyers would suffer losses of almost 10 percent, the data show.
The bond market worldwide is more vulnerable to losses than at any time on record, based a metric known as duration, index data compiled by Bank of America show. The risk has ballooned as issuers worldwide took advantage of the decline in borrowing costs to sell more and more longer-term bonds.
This probably means we end up seeing all these reverse in a very unpleasant fashion, Weisman said.
(An earlier version of this story corrected the ninth paragraph to show Austrias government removed support for Heta, not a guarantee on the bonds.)
–With assistance from Saleha Mohsin in Oslo, Eshe Nelson in London and Julia Leite in New York.
