Paying to Play (or Losements)

"A nickel ain't worth a dime anymore." - Yogi Berra

In the investment world, paying to play is synonymous with pretty much all investments - you have to put up the money to buy and pay the broker to cross the transaction with the seller.  Both of these require you to pay up and then you are playing the game.  After that you expect that the investment will produce a return commensurate with the risk - the risk free rate of return plus the risk premium,  If you do an exceptional job then the total rate of return exceeds the expected return earning the investor so called Alpha or return in excess of the risk of the investment.

In the world of loans and bonds the investment is relatively simple, lend the borrower money, write down the terms of the investment which include the interest rate, monthly payments of principal and interest (or sometimes interest only) and the date at which the investment matures.  During the term of the note, particularly if it is to a high quality borrower, things pretty much go according to plan and at the end of the term the money is freed up to invest in the something new.  Nowadays though not only are the bond investors paying to play but they are paying to lend!  A nickel sure ain't worth a dime anymore Yogi!

While this phenomena has not yet reached the shores of the United States, in Europe and Japan government bond yields have turned negative.  It may be that this is a temporary thing but recently the Swiss 10-year, the German 5-year and the Japanese 3-year bonds were all producing negative yields meaning that if you were to buy these investments that the return at the end of the rainbow would be negative - you would receive back less than what you invested, guaranteed!

Now why would anyone in their right mind make that investment?  Why would anyone invest knowing that they are guaranteed to lose money?  The first reason is that the security of those notes is considered exceptional so while you will lose some money you are guaranteed to receive the majority of it back which for some offsets the risk of placing it in a bank or beneath your mattress.

Alright, so not many people would make this investment so there must be more to it than that and the next reason is that these countries are struggling with the very real threat of sustained deflation.  In this environment with prices falling faster than the losing investment you actually come out ahead.  As an example if you invest $100,000 for five years in the German Bund and receive $99,000 back at the end of the term but the BMW that you were considering buying has dropped in price from $100,000 to $90,000 in the same time then you have come out ahead and you effectively earned roughly 10% on the investment.  Not bad considering the low risk.

Another reason for buying these investments (it is really hard form me to call them that, maybe I should change them to losements) is that you have an expectation that the yield will drop further making it a profitable trade.  As you know as the yield drops the price of the bond rises so by buying them there may be a trade worth making if the rate drops even further.  I would think this a risky bet but there are those that will trade anything, which leads me to my final reason; there are many funds that are forced to invest a certain amount of their funds into these assets due to the way that their prospectuses are written.  In order not to fall out of compliance they continue to plow money into these losements (that felt better).

At present there is almost $4 trillion in these losements and as the world struggles to keep deflation at bay, more and more of these bonds are coming to market because central bankers continue to print money in an effort to stave off deflation.  Looking at these numbers it is pretty easy to see why the 10-year Note in the United States continues to lower yields even as the economy starts to recover and the stock market breaks to all time highs.  While it is hard to imagine we in the Unites States may find in a few years time that we are wishing for 1.90% on the 10-year Note just like people are lamenting now about the 3.00% level of a few years ago.