A sign is enough

2014 provided its share of stockmarket confirmations (the US is running faster than Europe), but also its share of surprises: the rouble lost half of its value while shares listed in Shanghai jumped 58% over one year. Closer to home, the spectacular growth in German government bonds (+12% over one year) can also be ranked among the surprises of 2014.     

As new forecasts are being made, we could ask ourselves a naive question: can German bonds, the champions in performance terms, fare just as well in 2015 as they did in 2014?

Simple questions often prompt elaborate answers, and ours is no exception to the rule. With an actuarial yield on German government bonds of 0.5%, another way of asking the previous question is to ask at what level the actuarial yield would stand at the end of 2015, if the bonds gain a further 12% this year.

The answer is bound to vary from one valuation model to the next, but with one constant factor: the resulting figure would be preceded by a minus sign. If German bonds witness the same growth in 2015, their actuarial yield would stand at around -0.7%. This result is absurd: who would want to invest money over 10 years in order to obtain a negative yield? We can logically conclude that the bonds will at best reach the price that corresponds to an actuarial yield of zero. This reasoning leads to a more acceptable result with possible growth in 10-year German bonds for 2015 of 5% maximum.

The intellectual satisfaction provided by this figure is only temporary: when studying the rates curve as a whole, we note today that German yields are already negative for maturities up to five years. A negative long/medium-term investment is perhaps absurd, but it is nevertheless widely spread in fact. To the naive question asked initially, the answer is more: yes, a growth level as spectacular as that seen in 2014 is still possible in 2015. This “simply” implies that we are heading towards negative territory in long-term rates.

“On the stockmarket, we always underestimate the extent of movements”. The performance by the German bond market is a clear illustration of this old stockmarket saying…

But readers should be reassured: we have other investment ideas for 2015 than buying German bonds! We will not position ourselves in this ongoing trend and a prospective 10-year rate in negative territory. However, the virtually-zero rates backdrop in Europe (whatever the preceding sign!) is a reality that is well set in the minds of investors. To get the better of this passive strategy in 2015, we will need more imagination and probably more risk-taking. This reality will also imply a search for businesses with high cash generation… and above all, accepting more volatility, which is the unavoidable flipside to significantly positive potential remuneration.

Didier Le Menestrel