Ten years ago today, Greek 2 year yields hit a then all-time record low of 1.24% before skyrocketing over the next few years as investors realised that the country’s A1 rating was just an illusion. At the time most investors seemed comfortable lending to heavily indebted countries like Greece despite the obviously inadequate compensation for the risks. Within 12 months the country was openly discussing default and by 2012 the inevitable had become a reality.
At Stratton Street we had been warning of the problems faced by Spain, Portugal and Greece throughout 2009, based on our proprietary Net Foreign Asset model. Ten years later, what have we learned? Judging by the holdings of many bond investors, not a lot. With around USD 17tn of bonds trading with a negative yield, clearly there are a large number of investors willing to make investments which are guaranteed to lose money. Lending to safe credits on negative yields is one thing, but lending to risky credits with the certainty of a negative return is quite another.
Take Portugal for example. This is a country with net foreign liabilities in excess of 100% of GDP with 2-year bond yields trading at minus 0.54%. Paying for the privilege of lending money to Portugal makes even less sense than lending to Greece in 2009 but this doesn’t seem to stop investors from doing that. Other than ‘my bond index tells me to’ it is hard to rationalise why investors would choose to take such risks. If it goes well you lose a small amount of money and if it goes badly you lose a large amount of money does not seem to be an investment approach that will stand the test of time.
However, irrationality is a recurring theme in financial markets. One of my favourite books, “Extraordinary Popular Delusions and the Madness of Crowds” by Charles Mackay, first published in 1841, documents numerous examples of such irrational investor behaviour. What the book also highlights is that these irrational periods, whilst they can persist for long periods, do not last forever. Some varieties of Tulip Bulbs became the most expensive objects in the world in 1637, before the subsequent collapse.
Whilst the magnitude of returns may not have been as high, anyone holding 2 year Greek yields in May 2009 will have made money for a few months before suffering significant losses. Today, lending to indebted countries like Portugal or Spain on negative yields may also make you money over short periods, if you are lucky. But if there is one lesson we should all have learned from the events of 10 years ago it is that it doesn’t pay to take unnecessary risks. Instead of timing your way in and timing you way out, it makes more sense to avoid the risks in the first place. We don’t hold any bonds from heavily indebted nations and we don’t hold any bonds with negative yields. And more importantly we don’t hold any bonds which are both from indebted nations AND have negative yields.