Alternative solutions to cash
"Yes, it's difficult to find safe and profitable ways to invest money" said Jens Weidmann, president of the German central bank, in an interview to the newspaper Süddeutsche Zeitung on 13 December 2019.
Indeed, monetary policies pushed down the Bund yield to −0.2% at the end of 2019, well below its historical average (5.7%).
Since June 2014, the ECB has been charging banks that deposit their cash with it. As this situation continues, the result is negative interest rates on large bank deposits in euros. To escape this, there is no alternative but to invest and diversify to reduce the risks. There are solutions, even for investors with a defensive risk profile.
On 5 June 2014, the ECB announced the unthinkable: depositary interest rates were going to turn negative. Commercial banks would therefore have to pay to place their money with the institution. Pay to place...an aberration which was necessary to force banks to lend to the real economy (households, companies) rather than hoarding money with the ECB, and so the economy was set to pick up again. However, banks must also comply with prudential rules. They therefore need to find a balance between lending more to place less with the ECB and paying less (commercial banks in the eurozone pay a rate of 0.50% on part of their cash, i.e. a cost of €7 billion in 2018), and maintaining their solvency ratios.
The introduction of negative rates by the ECB caused short-term interest rates and bond yields to fall. On 15 January, 38% of eurozone bonds were trading at negative yields to maturity. Negative yields are also present in Japan, Switzerland and Denmark, among other countries. In the world 19% of bonds have negative yields.
This prolonged low-interest rate environment had a severe impact on financial institutions' margins. Furthermore, some eurozone banks have decided to pass on the cost of negative ECB rates to their customers. To put it plainly, they follow the idea of Swiss and Danish banks by charging for deposits above a specific amount.
How can individuals escape this?
A quick answer would be to keep one's cash in a safe, at home (which would pose obvious security problems!) or at the bank. One million euros in 200-euro bills (the 500-euro banknote is being phased out) represents a pile of 16 cm long, 8 cm wide and 1 metre high. As high-denomination banknotes (200 and 100 euros) are often refused by retailers in some countries, the ideal solution would be to keep only 50-euro banknotes, which would then amass a 4-metre high stack, or 43 litres in volume. Beyond the storage considerations, this money would yield nothing and the individual would be exposed to an erosion of purchasing power in real terms of around 1.3% per annum (the level of inflation in the eurozone). It is therefore better to invest money and diversify one's assets to reduce the overall portfolio risk, a key criterion for defensive investors. Here are a few investment solutions that deliver a return at least close to inflation and historically such solutions have relatively low volatility.
Bonds in euros
Opportunities are limited in the eurozone. Sovereign bonds (the least risky) have negative yields on maturities of up to 7 years in most eurozone countries. Italy and Greece are the exception as their 3-year yield is already positive, at 0.2% and 0.1% respectively.
In order to find yield, while remaining invested in good quality bonds (Investment Grade- rated issuers), it is necessary to focus on subordinated bonds issued by companies. They are riskier than senior bonds, since they come second in the order of repayment priority in the event of bankruptcy, but the risk is ultimately limited if we choose Investment Grade issuers.
Subordinated financial debt offers a yield of around 1.0%, compared with 0.3% for 'senior' bank bonds.
Hybrid bonds are issued by non-financial corporations, with a variable (unguaranteed) coupon, an unfixed (perpetual) maturity date and the possibility of early redemption at the issuer's discretion on dates known in advance. The yield, calculated by taking into account the first possible early redemption date, is close to 1.5%. By way of comparison, 'senior' bonds only yield 0.4%. High coupon hybrid bonds whose call date is not in the too distant future should be favoured.
Bonds in dollars
Yields on dollar-denominated bonds are higher than bonds in euros, but obviously an investor whose reference currency is not the dollar is exposed to currency fluctuations, unless he invests via units of funds that are hedged against exchange rate risk. Government bonds are very low risk and very liquid. We prefer those with short maturities because long bond yields do not offer substantial additional compensation. American bonds with maturities of between 1 and 3 years offer a yield of around 1.6%.
Investment Grade Corporate bonds in the US are also attractive. While they are a little more volatile than Government bonds, they offer a higher return, in exchange. For the highest-rated bonds (AAA, AA and A), yields range between 1.9% for short maturities (1 to 3 years) and 2.3% for BBB-rated bonds.
Asset Backed Securities (ABS)
An Asset Backed Security is a fixed-income product whose revenues come from a loan portfolio with collateral. This set of assets is generally made up of a homogeneous group of small illiquid assets such as mortgages, auto loans, lease-financing and credit card debt. All the flows generated by these loans are used to pay the interest on each ABS tranche, with in priority the 'senior' tranche and then the most 'junior' tranche. Like a traditional bond, ABS pay interest periodically and the principal is repaid at maturity (except in the event of bankruptcy). The interest is very often based on variable rates that limits interest rate risk in the event of a rise in interest rates.
The European ABS market is characterised by relatively strong fundamentals, a reinforced regulatory framework since the 2008 financial crisis, and relatively attractive returns compared with cash. The ECB buys them every month as part of its asset purchase programme.
In an environment of low interest rates in the eurozone, ABS therefore represent a good way of diversifying while maintaining an attractive risk/return ratio versus that of the money market. The best tranches, rated AAA, have negative yields (-0.2%), those rated AA offer 0.3% and those rated A, 0.8%. The higher the rating, the lower the volatility.
Newcits funds offer the opportunity to profit from the rise (and the fall) in asset prices, depending on the strategy. We favour Global macro strategies as trade tensions and populism defy certain sectors, which should generate volatility and hence opportunity. In addition, dispersion across Emerging Markets helps to identify investment ideas. Long/short equity strategies are also attractive because they can exploit structural factors such as low returns and disruptive innovations. Long-term expected returns (10 years) are around 3.5% with a return volatility of around 8.2%. There are, however, funds with reduced volatility of less than 2%.
Cash no longer remunerates, and can even cost money. Moreover, low rates weigh on the profitability of bond investments. The fixed-income products explained above correspond to defensive solutions that should help offset inflation. Investors can also turn to the other major asset class, Equities, as companies are paying substantial dividends that contribute to the total return. On 1 January, the dividend yield on shares averaged 3.5% in the European Union and 1.8% in the US, thus higher than the yield on bonds. Investors who do not wish to be fully exposed to the equity risk can look to multi-asset funds because they offer an attractive risk/return ratio. An increasing number of SRI (Socially Responsible Investment) funds are also available to investors who are interested in social and environmental issues.
Cash and cash equivalents: assets that are by nature liquid (can be rapidly converted into cash) and safe (their value fluctuates very little). They include, for example, cash, bank deposits, life insurance funds in euros and some financial investments with maturities of less than one year.
Investment Grade refers to high-quality credit ratings, as opposed to High Yield.
Senior bonds are bonds that are reimbursed as a priority in the event of the issuer going bankrupt.
Subordinated bonds are bonds that, in the event of the issuer's bankruptcy, are only repaid after all other claims. Holders of a subordinated bond are, however, repaid before shareholders.
Hybrid bonds have characteristics that are common to bonds and equities. They are very long-term subordinated securities (with no maturity date). However, the issuer may decide to redeem the bond early, on pre-determined dates (often 5 or 10 years after the issuance date). The hybrid bond normally pays a coupon but the issuer can decide to suspend or cancel it without triggering a default procedure.