Are bonds once again becoming an option for everyone?
The European Central Bank (ECB) has announced the end of its bond purchases. However, as the bond supplywill not decrease, new buyers will be needed in the future. In recent years, bonds have increasingly become a specialised topic for selected professional investors and the ECB. Dr. Volker Schmidt, Senior Portfolio Manager at Ethenea, analyses whether bonds could nevertheless also be attractive for retail investors in the future.
Low yield opportunities for sovereign bonds
For a number of years now, institutional investors have dominated the bond market. “After all, no retail investor can do anything with negative-yield bonds,” says Volker Schmidt. “The usual minimum investment of EUR 100,000 also makes bonds of little interest to retail investors. In contrast, professional investors have continued to buy euro-denominated bonds for a range of reasons. Some of them have no other choice because their statutes require it, such as insurance companies, pension funds, pure bond funds, or multi-asset funds with a bond focus. Other investors use bonds for diversification, hedging reasons, or as a source of performance,” In fact, during the last five years alone, there were two periods of strong price gains on euro-denominated bonds – in 2019 and after the peak of the Covid-19 crisis in March 2020. In 2019, bonds posted gains even without particularly strong additional demand from the ECB, while in 2020, purchases under the PEPP (Pandemic Emergency Purchase Programme) were largely responsible for this, he says. However, in 2021, broad bond portfolios recorded a loss of just under 3%, and in the first months of 2022, of roughly 8%.
In light of this, Schmidt assesses the yield opportunities for retail investors as rather low. “After the ECB signalled a slower pace of bond purchases and is no longer categorically ruling out interest rate hikes this year, yields on 10-year German sovereign bonds rose significantly. Currently, they have a yield of around 0.9%, or a coupon of 0% and a purchase price of around 92%. However, this is very low by historical standards, and after deducting purchase costs and annual portfolio commissions by the custodian bank, there will be very little left over for retail investors.” Typically, lower risk is a higher priority for buyers of sovereign bonds than the yield to be achieved, so possible temporary price losses tend to be less of a concern. However, high inflation rates mean that sovereign bond yields close to 0% remain largely unattractive to retail investors.
Corporate bonds: yield opportunities with potential downsides
Corporate bonds, on the other hand, usually offer significantly higher yields, but have the decisive disadvantage for retail investors that many bonds have a minimum investment of EUR 100,000. On average, bonds with a quality rating (investment grade) and a maturity of about five years still pay a yield of 1.5%. However, this is also still low in a historical comparison. According to Schmidt, quality losses have to be accepted for higher yields. “If you are prepared to make small concessions in terms of the quality of the company, such as higher capital expenditure or lower margins, then returns of 3% are entirely possible.”
Overall, the yields for an investment in euro-denominated bonds are likely to continue to be unattractive for retail investors. A possible opportunity lies in the ECB’s tapering. If the bond purchases are discontinued completely by the summer, issuers are more likely to look for other buyers. One way to attract investors would be to reduce the investment. Another option would be to reintroduce free management of German sovereign bonds, such as that offered by the Federal Finance Agency until 2013. “It is possible that in the not-so-distant future, the friendly turtle, Günther Schild, will make a comeback and advertise German sovereign bonds again,” says Volker Schmidt. He already sees the potential for this. “According to Eurostat, private households in the EU would have had financial assets of EUR 32 trillion as at 30 December 2020. Of this, around 33% is in the form of cash and short-term deposits. We estimate that this figure is likely to have increased by at least 5% in 2021. Bond issuers will vie for this money and try to poach it from bank accounts that are still subject to penalty interest. It is possible that this will increase the pressure on banks to pass on the central bank interest rates, which are likely to rise this year, to their customers.”
Inflation concerns drive retail investors into equities
The Russian invasion of Ukraine only caused a short-term exodus to safe havens and sovereign bonds. Inflation, which was further fuelled by the war, has significantly increased the ECB’s willingness to raise interest rates and accelerate its exit from bond-buying programmes. “As yield rises in the low interest rate environment are synonymous with price losses on bonds, investors have quickly divested themselves of their bonds and returned to equities, still the best-valued asset class from the perspective of many retail investors,” says Schmidt, who also believes that future interest rate hikes and current bond yields will discourage retail investors from investing in bonds. “The key here is to put concerns about further price falls, which are entirely justified, into perspective. We are still a long way from inflation being offset by bond yields, and real yields will remain negative.” Loans also reflect monetary policy normalisation. The ECB has indicated that the reduced capital requirement for banks, that was introduced to stem the consequences arising from Covid-19 in 2020, will cease at the end of 2022. Therefore, banks are already preparing for this and increasing the lending standards, including for mortgage lending. The BaFin (Germany’s Federal Financial Supervisory Authority) is even going beyond this for the banks it supervises and has already increased capital requirements for banks, the so-called countercyclical capital buffers, and the special capital requirements for mortgage lending that will follow in 2023. Combined central bank measures would further consolidate the low yields.
