Is the safety of treasury bonds ancient history? [CINKCIARZ.PL ANALYSIS]

Aug 12, 2016 12:51 PM|

The treasury bonds of developed countries have been considered as a safe and stable source of income for years. However, the implementation of negative interest rates, as well as a strong involvement of central banks in the bonds market, cause these instruments to become very hazardous.

Marcin Lipka, główny analityk

The past quarters were full of information regarding the activity of central banks. They have been buying more treasury bonds and taking interest rates below zero. Moreover, the profitability of debt instruments is negative. Due to a constant inflow of such information, we began to get used to them, but also underestimate them. Very often, we don't even think of an increasing risk.

Taking into consideration the phenomenon of negative interest, it's worth asking this crucial question: how is it possible that by lending the German government 100 euro for ten years, you are obligated to pay them ten cents per year? A loan taken out in Switzerland will cost you even more. After ten years, you will have approximately 95 out of the 100 loaned francs. Who would agree to such unfavorable conditions?

What is negative interest?

Profitability of bonds depends on a few basic factors. The first one is the time of the loan (maturity period). Theoretically, the longer it is, the higher the interest. This is because there is a larger likelihood that the bond issuer will not fulfill the obligations.

Another element is the debtor's credibility. In the case of such countries like Germany, Switzerland or Holland, we may assume that the risk of their insolvency is near zero. Thus, we can ignore this matter.

In the third case that we have analyzed, the most significant element is the market interest rates. At the beginning of August, EURIBOR 3M (rate of three-month loans in interbank market which is expressed in euro) was at a negative 0.30% level in year on year relation. On the other hand, a three-month interest expressed in the franc was worth approximately 0.75%.

However, another question appears. Why are the banks lending themselves money and even paying extra? In this case, monetary authorities of particular countries come into play. Deposit rate of the European Central Bank (ECB) is currently at a negative 0.4% level. When it comes to the deposit rate of the Swiss National Bank (SNB), the current level is negative 0.75%.

Making things more simple – the ECB negative interest is a punishment for the banks that prefer to keep free capital on the ECB accounts or lend them between themselves, instead of giving loans to enterprises and consumers (this would increase the economic activity). In this case, negative interest is a certain type of a tax that banks have to pay for acting in a similar way.

Generous profits with low interest rates

Since we function in the market of negative interest rates and deposits that are below zero, we may imagine that instead of paying the banks for a “privilege” of loaning them money (as weird as it sounds), we may pay the German government by buying its treasury bonds.

Thus, is it justifiable to speak of this as a danger? Theoretically, investors know that they will lose if the profitability of a particular instrument is negative. Even if treasury bonds are bought for the nominal issue price (100 euro, for example), the debtor will have to pay extra into the entire operation.

The above remarks are true when it comes to bonds that are purchased directly from the issuer and kept until the moment of buying. The majority of treasury instruments is quoted on the market. Moreover, they have a defined price which is the function of its interest, at the moment of issue, as well as current market conditions.

In order to picture this relation, it's worth getting back to times of positive interest rates. We assume that at the beginning of 2014, the German government issued a ten-year bond worth 100 euro (the price of issue as well as purchase). It paid 2 euro (a coupon) per year for it, which is 2%. After nine months, the expectations regarding the future interest rates went from 2% to 1%. Currently, the German government is able to issue a new bond, but it will only pay 1% per year. However, how does the instrument from the beginning of 2014 behave now?

A treasury bond that was issued at the beginning of 2014 is currently worth approximately 110 euro. Why? Its price reflects the fact that the bond has an included coupon. It pays its owner 2 euro (approximately 2%). However, the bond's current interest is only 1%. In ten years, assuming that conditions remain unchanged, when buying a bond for 100 euro, the instrument, including a 2% coupon bought for 110 euro, will bring approximately the same income as the instrument including a 1% coupon bought for 100 euro.

Now, we are starting to reach the crux of the matter. If we would have foreseen a significant decrease in interest rates two and a half years ago, we could have earned more than 20% on a German ten-year treasury bond. During that time, its price increased from approximately 100 to more than 120 euro. This is because there was a decrease in interest rates from 2% to a negative level. However, what will happen if the trends turn?

Potential catastrophe?

If we look at the diagram of profitability of the European treasury bonds, we have been dealing with their constant decline. This means that the bonds issued earlier and kept in the wallets of investment funds that locate customer’s money in debt instruments, gained value the same way as described above.

Capital profits from these wallets have reached two digit values during the past years without problem. Repeating such positive results in the future is very unlikely. This would require either a decline of market interest rates in the area of negative 3%, or a move of the funds wallet toward bonds with an increasingly longer maturity period. This, on the other hand, would increase the future risk even more.

A pessimistic scenario for such bond wallets is the return of the European economies to the 2% future inflation level. If this happens, the bond prices would drop dramatically (an opposite relation to the previous example). In such cases, the losses could even exceed approximately 15%. This may concern instruments that are considered safe, as well.

Theoretically, the above examples concern the Polish market to a minor degree. Poland still has positive interest rates because there is no need for a strong stimulation of the economy. However, Polish and German debt instrument markets are historically bonded quite tightly. Thus, the direction of their moves is similar. If the debt prices in western Europe begin to fall, we may expect a similar situation in Poland.



Aug 12, 2016 12:51 PM|

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