First, if U.S. indexed bond funds are the largest U.S. buyers of global negative yielding bonds, then they could, at some future point in time, be the sellers of these same bonds. This could happen if they decide that the yield on the bond fund is not sufficient compensation for the capital risk they are taking. The indicated yield, for instance, on BNDX is 1.1%, and its duration is around 8.3, so a roughly 0.13% move in the global yield curve wipes out a year’s worth of yield. That’s a pretty skinny margin of error. Some of the tulip like bonds will trade like, well, tulips, once they are no longer fresh.
Second, since financial alchemy is what converts the low or negative yields into positive yields, any compression in cross-currency rate differentials can result in hastening the fall in the yield in these funds, since currency hedging cannot provide the additional “yield”. To this point, an aggressive cut by the Fed that reduces the difference between U.S. and foreign yields could result in a lower hedged yield. If the Fed cuts 50 basis points in the next meeting, suddenly the U.S. bond market could attract the attention of currency hedged investors out of Japan as well. A massive re-allocation out of European negatively yielding bonds then could result in the convergence of the yield spread between European bonds and U.S. bonds. Could this mean the start of another round of European debt problems that won’t have a simple monetary cure this time since yield levels are so low already?
Third, and most important, is the fact that the virtuous cycle of easy monetary policy and no inflation in the aftermath of the financial crisis has sucked money into bond funds at an incredible place. As trillions of dollars of cash have been created out of thin air by central banks, a large hoard of bond market holdings via low cost, passive indexed bond funds and ETFs has been the preferred way for both retail funds and many institutional investors to obtain exposure. The providers of the index funds do exactly what they say they will do; i.e. buy the bonds according to the weight in the index, regardless of price or future return prospects. The risk is that this virtuous cycle turns into a vicious cycle where they are forced to do what they have to do by the terms of their prospectus. If the bond market hits a rough patch, and investors exit their indexed bond funds, there will likely be indiscriminate selling of the individual bonds as well. This latent illiquidity of indexed bond ETFs has been only visible a few times in the past, and when it happens it is not pretty. The last time we saw a stampede out of an ETF was in February of 2018, when the volatility selling ETF XIV went from hero to essentially zero overnight. Clearly an indexed bond fund would hold up better than a levered VIX futures ETF, but we simply don’t know how much better.
So the takeaway is this: Only time will tell whether buying bonds at record low yield levels and record high prices is a good investment. I can argue both sides like all good two-handed economists even though I am not one myself. However, one thing seems clear – a large fraction of bond buyers are probably buying them on autopilot, paying little attention to yields. As long as the price of the bond is going up, it is hard to argue with doing more of the same since the value of the holder’s account is probably going up. We simply have to watch and see what happens once and if the tide turns. In the meantime, investors may want to consider getting out of indexed bond funds that own negatively yielding bonds and instead, consider buying some good old-fashioned treasury bills that currently yield almost twice as much! As they say, being passive is also an active decision, especially when it comes to being a creditor, which is what one is when investing in a bond fund.