These questions are at the core of the debate in an uncertain environment in which government institutions are playing a critical role in stabilising the economy and the financial markets as well as owning a large share of sovereign debt.
What is the appeal of investment grade sovereign bonds?
Since the central banks’ intervention to address the massive financial crisis, real yields (that means yields adjusted for inflation expectations) have been shunted into negative territory for both the eurozone and the US over a benchmark 10-year maturity. In practical terms, this means that investors wanting to invest over this time horizon are guaranteed to lose money if the effects of inflation are taken into account and their investment is held to maturity. So why are government bonds with negative yields still so popular with a variety of investors? The short answer is that there are few alternatives for investors looking for a liquid investment with no credit risk and a degree of visibility on cash flow. Sovereign bonds issued by AAA-rated countries such as Germany and the US are considered to be risk-free in terms of credit and liquidity. Some institutions such as banks and insurance companies are obliged to invest in these high quality bonds in order to meet the liquidity and credit thresholds imposed on them by regulations. For investors who are not constrained by such institutional requirements, these negative-yield bonds have a certain appeal because they can help to regulate a portfolio’s volatility and protect part of the portfolio in a crisis scenario.
Diversifying a portfolio with sovereign bonds exploits a decorrelation between different financial assets in order to protect the portfolio during times of turbulence. The US Treasury note is a good example and its safe haven status was amply demonstrated when its yield plummeted at the start of the health crisis.