No. of Recommendations: 12
Charles Gave, Chairman of Gavekal Research, recently recounted a conversation with a European pension fund manager who had been informed by the European pension fund regulator that he (she) must invest more of her clients' cash in (negative yielding) European government bonds, because the rules say that cash is too risky for pension funds. (My guess is that the pension rules were made at a time when holding non-yielding assets, such as cash or gold, were considered riskier than government bonds, which would presumably produce positive income rather than mere dead money weighing down pension fund investment returns.)

Unfortunately for the European pension fund manager, those Euro bonds - into which the rules force her - are negative-yielding bunds for which she must pay 103 Euros (€103), promising she will only receive 100 Euros (€100) in 5 years. This guarantees that her pension fund will lose money to the tune of -3% in 5 years.

Charles Gave described, in accounting terms, the effects that negative yields will have on pension funds, banks, and insurance companies, as follows:

This [accounting] approach got me thinking where those losses would be booked in the case of pension funds, insurance companies and banks? And what would be the long term effects?

...How this loss appears will depend on the type of investor in question:

Pension fund.

The €3 loss will reduce the market value of assets by €3. Holland also has a rule that pension funds must buy more government bonds the closer they get to being underfunded. Yet buying such negative-yielding bonds and keeping them to maturity ensures losses, making it more likely the fund will be underfunded, and so forced to buy more loss-making bonds (spot the feedback loop). Soon the fund will be distributing returns from capital, rather than returns on capital. Hence, it is not inflation that will destroy [European] pension funds, but the mix of negative rates and rules that stop managers from deploying capital as they see fit...


As a leveraged player, let’s assume it lends a fairly standard 12 times its capital. This capital has to be invested in “riskless” assets that are always liquid...
Today, the government bond market plays the role of “riskless” (you have to laugh) asset, which has no reserve requirement. As a result, banks are loaded up with bonds issued by the local state. Now let us assume that a bank has just lost €3 on the zerocoupon bond mentioned above. The bank’s capital base will be reduced by €3. Based on the 12x banking multiplier, the bank will have to reduce its loans by a whopping €36 to keep its leverage ratio at 12. Hence, the effect of managing negative rates while also respecting bank capital adequacy rules means that the capital base can only shrink.

Insurance company.

These institutions have two centers of profits. First is the core business of assuming risk on behalf of clients. Second, they manage premiums paid by the clients in a way that aims for a profit over the present value of the risks covered. A standard solution is to cover the maximum amount of risk with a government bond of similar duration to the client’s contract period, and then put the remainder into equities or real estate to help build up the firm’s capital base. This gets very difficult when government bonds offer negative yields. The insurance company could raise its premium by the amount of the expected loss from holding the bond [which is likely to reduce its customer base]... or it could just underwrite less business. Either way, it will have less money to invest in equities and real estate. Simply put... either the client pays more for insurance, ...or the insurance company takes a hit to its bottom line.

The conclusion is that negative rates must eventually destroy the longterm savings industry run by pension funds, banks and insurance firms.
[Emphasis added throughout.]

If your investment bets are guaranteed to lose money, then to engage in betting at all is just stupid. Charles Gave's story ends with an acknowledgment of this conclusion.

To my own thinking, the insanity of guaranteed negative yielding "investment" cannot continue forever, no matter what regulators and central bankers say or do.

Committing one's hard-earned money to guaranteed nominal loss is reprehensible - and it will eventually result in revolt by ordinary investors and savers. I am not sure whether the revolt will take the form of hoarding cash, gold, precious metals, or Bitcoin. But I am sure that revolt will come.
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