Why Would Anyone Do This?
There are a host of reasons that an investor might want to pay for the privilege of owning a German five-year note. As a U.S. investor, buying a euro bond is a pure currency play—you’ll make money if the euro rallies. That’s part of what’s behind the negative yields, for instance, in the now free-floating Swiss franc. And even with a negative yield, if the economy goes into deflation, your negative yield is still positive in real terms.
So why not just hold cash? The short answer is that if you were a rational actor with no concerns about the safety of your cash, you would. You’d just stick bills in a vault.
But many, many institutions have rules that make this a virtual impossibility. The average institutional investor who wants safety actually can’t just leave it all in the cash account at their custodian, because banks aren’t guaranteed. They can and do go bust from time to time. Just look at how Greek investors have been withdrawing their cash from Greek banks.
Even here in the U.S., if you leave $1 million in cash at Citibank, you’re not actually backed by the FDIC past $250,000. For this reason, almost all institutions use short-term bonds for their “cash” holdings; in many cases, under strict rules—in other words, they have no choice.
The Index Problem
There’s another category of people who don’t have a choice: indexers.
I’m a died-in-the-wool indexer, but sometimes they lead to unintentional exposures. Consider the iShares 1-3 Year International Treasury Bond ETF (ISHG | B-78). Its mandate is to track the S&P/Citigroup International Treasury Bond Index Ex-US 1-3 Year index.
There’s simply no way for this fund not to end up buying one- to three- year bonds from Germany—it’s in the index rules. And that means they’re a natural buyer of negative-yielding bonds, like it or not.
The overall impact on the portfolio is just what you’d expect. A trip to the iShares website shows the 30-day SEC yield (a backward-looking 30-day measurement of portfolio yield) for ISHG at -0.15 percent.
Its overall portfolio yield to maturity (the expected yield just from holding the bonds it has right now till maturity) is ever so slightly positive, at 0.09 percent—but that doesn’t include any fees, which are a hefty 0.35 percent.
So why might you, as an ETF investor, decide to invest in ISHG? Well, there’s about $135 million worth of investor money in it right now. Some of that money may have the same constraints as institutions. Some of it may be betting on a run in the euro.
And some of it? Well honestly, some of it may just not be paying attention. Which leads to the moral of the story, which is pretty much always the moral of the story: Know what you own, and know why you own it.
At the time this article was written, the author held no positions in the securities mentioned. You can reach Dave Nadig at [email protected], or on Twitter @DaveNadig.