Column: Nestle, negative yields and a different deflation - James Saft

[February 06, 2015]  By James Saft

(Reuters) - Corporate bonds did outstandingly well during the great deflation in the 1930s but this time round may be, well, different.

To see how, and why, this is true look no farther than chocolate-to-bottled-water giant Nestle’s euro bond expiring in October of 2016 and its negative yield.

That’s right: it is possible to pay for the privilege of funding Nestle’s ongoing operations, this despite the fact that it is definitely not a charity.

Of course, you will, in all probability, get your money back, Nestle being giant, strong and rated Aa2. And given that prices in the euro zone are down 0.6 percent on the year to January, there is every chance that the money you get back from Nestle will buy more chocolate than when you and the euros were parted.

And Nestle does offer a yield pickup, excuse the joke, on a huge chunk of the euro zone sovereign bond universe. Finland sold five-year paper the other day for a negative yield, German yields are negative six years out, while those in Austria, Sweden and the Netherlands cost you money to hold for five years. France, always a bit more of a risk, is priced with negative yields for maturities up to three years.
 

Note please that while Nestle has the Rumpelstiltskin-like ability to make money selling water, those euro zone governments can levy taxes and all have calls on a central bank with a printing press. That, the story goes, is the point. The European Central Bank in launching quantitative easing is creating the conditions which turn the reach for yield into this kind of defenestration. Yields have compressed along the risk spectrum and when you get to the safer end of the corporate bond rainbow there is simply no reward, in yield terms, to be found.

So while Nestle investors like getting their money back as much as the next guy, the phenomenon is probably telling us a bit more than simply a macro call on euro zone deflation and ECB bond buying.

One interesting historical parallel is the absolutely fantastic performance of U.S. corporate bonds during the 1930-1933 deflation. During those years U.S. corporate bonds returned 6.7 percent on an annualized basis, even before you take into account a cumulative deflation approaching 25 percent.

Investors did suffer quite a few defaults during the period and yields were lower than they otherwise might have been given that public markets were principally open for higher-grade issuers.

A TALE OF TWO DEFLATIONS

A comparison of now and then, however, should give investors reason for pause. Corporate bonds rated Baa yielded just under 6 percent in December 1929 and Aaa issues were at 4.67 percent. And those returns were earned despite a spike in yields up to 1932, one that took Baa yields above 10 percent briefly. Pretty juicy given deflation. Thus the rub: euro zone corporate bonds now yield very little, only a bit above 1 percent for Baa-grade and a good deal less, and sinking, for the better-quality stuff.

All of this implies that we are going to need quite a bout of deflation to drive returns in coming years, considering the starting point.

Now you could argue that the very small corporate bond market in the U.S. in the 1930s was terribly inefficient, and that part of the reason the country had such a tough time was that firms found it so hard to obtain financing. That led to good returns for those willing to hold corporate bonds then, but the corollary should be less good returns, but possibly better economic ones, now.

One of the big differences is that markets now have such touching and complete faith in the determination, and ability, of central banks and governments to keep markets open and funding easy. The experience of 2008 was that when markets did freeze, the authorities did 'whatever it takes' and firms were not exposed to the expected refinancing risk.

That's as may be, but it is amazing to consider that the yields are being offered on bonds in a currency which may not have a stable line-up over the next two or three years, much less a stable international value. You hate to think what the corporate bond returns might look like for dollar-based investors.

The other irony here is that while liquidity is felt with fire-hose strength among those firms large enough to access public markets, the quite large rump of euro zone business which depends on bank lending is less well watered, by far.

Holding corporate bonds may result in considerably worse returns in this particular deflation.
 

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at [e-mail] and find more columns at http://blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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