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Bond Alchemists Turn Negative-Yielding Debt Into Tidy Profits

Anooja Debnath and John Ainger
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Bond Alchemists Turn Negative-Yielding Debt Into Tidy Profits

(Bloomberg) -- For the canny investor, the most negative yields since 2016 have done little to dim the allure of German bonds.

While sub-zero rates imply a cost to own Europe’s safest assets, there are still ways to make money on those bunds. The most popular strategies are known as carry and roll, and OppenheimerFunds Inc. and Mizuho International Plc are using them right now in the market.

The carry trade aims at earning the difference between the cost of borrowing money and the yield on bonds, while roll indicates the typical increase in debt prices as time to maturity decreases. While 10-year yields in Germany have fallen around to minus 0.08% and 30-year rates to about 0.57%, they are still well above three-month interbank funding rates that are close to minus 0.5%.

“With short-term rates at negative 60 basis points, there is still attractive carry in the European curves,” Alessio de Longis, a New York-based portfolio manager at Oppenheimer, which has around $234 billion under management. “That is a good position to hold in terms of having sustained power, even without substantial capital appreciation.”

Carry and roll provide some consolation to investors struggling to make money when more than $10 trillion of the world’s debt has negative yields. German benchmark yields fell below zero in March for the first time since 2016 as a euro-area economic slowdown suggested the European Central Bank will be stuck with negative policy rates for much longer than previously thought.

How It Works

It’s a safe bet but not a terribly lucrative one, and depends on low market volatility and an upward sloping yield curve -- meaning rates increase in line with maturities. Here’s how it works:

A typical carry transaction involving bunds at current yields would mean borrowing around a negative 0.55%-0.60% and using the proceeds to buy 30-year notes that offer almost 55 basis points in yield. That would offer a combined carry and roll of approximately 3,000 euros ($3,348) on an investment of 1 million euros over three months, enhancing any returns.

Adding to the trade’s allure is the fact that German bonds are less vulnerable to day-to-day swings than riskier markets such as Italy, which is plagued by political risks, according to de Longis. Indeed, the main risk to carry trades is that a slide in bond prices could wipe out any interest income earned and, even worse, force the investor to close the trade at a loss.

While Italian debt pay much higher yield than that of Germany, much of the premium is lost once adjusted for volatility. Spanish and French securities offer similar stability as German ones, as do Sweden’s bonds, according to de Longis. As trade tensions between the U.S. and China flare up, de Longis is staying overweight longer-dated bonds, particularly in Germany.

Another way to profit from bunds is to bet on changes in the yield gap between short- and long-dated securities.

Ten-year German yields fell as low as minus 0.13% last week. Still, the country’s yield curve remains one of the steepest among developed markets, with 30-year rates trading around 120 basis points above two-year ones. A similar spread in the U.S. is currently at 59 basis points.

That’s prompting Nicholas Wall, a portfolio manager at Merian Global Investors, to bet that the German five- to 30-year yield curve will flatten relative to its American equivalent.

“If the environment is benign, we expect some pick-up in the German data will flatten the curve,” he said. “In a more risk-off scenario, where China-U.S. tensions escalate and/or the U.S. imposes auto tariffs on the European Union, we would expect 30-year bonds to outperform too,” leading to bigger declines in long-end yields, he said.

Risks Linger

Not everyone is bullish on long-tenor German bonds.

“We are actually very much in favor of core bonds against the periphery but, at the same time, we wouldn’t want to take outsized bets in terms of duration,” said Maximilian Kunkel, the chief investment officer for Germany and Austria at UBS Wealth Management.

Should the nascent signs of the region’s economic recovery feed into inflation over time, Germany’s longest-dated debt could see “out-sized losses,” according to Kunkel, whose firm had $2.26 trillion in invested assets. At the same time, he doesn’t recommend having a short position in bunds given the ECB’s dovish policy slant.

The central bank’s deposit rate is already at a record low of minus 40 basis points and money-market prices now imply investors have begun to anticipate further monetary easing early next year.

That suggests carry trades are here to stay -- Mizuho’s Peter Chatwell is in favor of ways to “monetize these very low rates.”

“The market is very much thinking the ECB probably won’t be able to hike rates and so the next move could well be to restart their quantitative-easing program,” London-based Chatwell said. “Monetizing carry and roll actually still makes the European government bond markets very attractive.”

(Updates prices throughout.)

To contact the reporters on this story: Anooja Debnath in London at adebnath@bloomberg.net;John Ainger in London at jainger@bloomberg.net

To contact the editors responsible for this story: Ven Ram at vram1@bloomberg.net, Anil Varma, Paul Dobson

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