An inversion of investing first principles

"May you live in interesting times" is an English expression widely reported (and debated in equal measure) as being a translation of a traditional Chinese curse. Interesting is a euphemism for lots of things, but the expression is typically used ironically, with the implication that less interesting times are more tranquil and orderly. 

As far as Central Banks and monetary policy is concerned, the times we are currently living in can be described, without fear of hyperbole, as extraordinary. The European Central Bank’s recent announcement that it is set to keep interest rates on hold for the remainder of 2019 means that Mario Draghi is now certain to complete his eight years as the president without ever having raised interest rates.

Bizarre times we live in

I’m barely old enough (an expression I use increasingly rarely) to recall the period of dramatic increases in interest rates during the 1970’s and early 1980’s. Just over a generation later and the goings on in bond markets must appear to be equally, if not more, remarkable.  

We have become quite familiar over the last number of years with Government debt with negative yields and recently this has ticked back up as central banks abandon plans to tighten monetary policy. 

A bond with a negative yield guarantees a return of capital that is less than the original investment. The idea of lending money to a Government with the guarantee of losing money — if you hold the bond to maturity — has always struck me as bizarre. But what about lending your hard-earned money to companies? Corporate bonds with negative yields emerged in Europe in 2016, but were seen as a temporary distortion arising out of the European Central Bank’s scheme to buy up tens of billions of euros of company debt. 

But sub-zero corporate debt is back. In the past couple of months, France’s Louis Vuitton Moet Hennessy (LVMH) and Sanofi have both raised funds at negative rates (Sanofi was one of the first companies to do so previously in 2016). When interest rates in an economy turn negative, this should probably not come as a surprise as some companies are arguably a better credit risk than many Governments. According to Bloomberg, 2 out of every 5 Euro Government bonds are trading at below-zero yields. Retail investors at banks have been spared negative deposit rates thus far, but corporates depositing at the same institutions have been paying for the privilege for some time now. So, in a relative sense the resurgence of sub-zero corporate debt seems less notable.

Inversion of first principles

But from an investment perspective it truly is an inversion of first principles. Shrewd investment involves bearing risk when well paid to do so. Paying to bear it, is as flagrant a transgression of Buffett’s first and second rules as is conscionable – 1, don’t lose money and 2, don’t forget rule no. 1. So, what can explain the rationale for recent events in credit markets? 

It’s not that there are a bunch of irrational investors piling into sub-zero corporate debt. The credit market mania described herein is symptomatic of the highly unusual monetary policy environment we find ourselves in post great financial crisis. But it does bear thinking about.

An investor in the equity of Sanofi and LVMH is currently buying into an earnings yield of 4.7% and 3.7% respectively. Granted it is not a straight forward comparison. A company’s equity is essentially perpetual (the aforementioned debt has a specified maturity date) and credit risk is higher as equity holders will bear risk before debt holders have to. However, it is nonetheless instructive in terms of what it says about perceptions of risk and the price of it in the market. 

The pricing of risk

Is the pricing of risk appropriate if I can invest with the prospect of earning just shy of 5% over an indeterminate timeframe versus paying to lend money to the same company over a finite one? 

Maybe it is. But I suspect that inappropriate measures of risk have as much to do with this outcome as any other factor. A company’s debt will exhibit low levels of price variability. That signals to investors that it can be labelled as low risk, thanks to a financial services industry that explicitly links risk to volatility; as opposed to real-world measures like the prospect of losing money. Linking risk to the probability of capital loss is so obviously sensible as to be past hoping for.     

For hard-pressed low risk investors seeking some sort of positive yield, the return to a more ‘normal’ interest rate environment probably can’t come fast enough. We may long for a return to uninteresting times, but I can’t ever recall a time in financial markets that could be described thus.