Now That’s Just Crazy, Part 1: Junk Bonds With Negative Yields

by John Rubino

A central bank that’s desperately trying to ignite a borrowing/spending frenzy to offset an incipient recession has one wish above all: That the currency it’s creating flows beyond safe-haven assets and into riskier niches. Call it the democratization of credit or Ponzi finance. Either way, the result is a lot of borrowing and spending, which solves the immediate slow-growth problem.

So it must come as a pleasant surprise for monetary authorities that a growing number of “high-yield” bonds are trading with negative yields. You read that right: some junk bonds now yield less than nothing.

So far, this is happening mainly happening in Europe, where the ECB has been soaking up the bonds of junk countries like Italy, producing Italian government bond yields comparable to those of the US and not far from Germany’s. Now some of this torrent of newly-created euros is flowing into the corporate equivalent of Italy, sending the share of one-step-above-junk BBB rated bonds with negative yields to double-digits. Meanwhile, the share of actual junk bonds with negative yields is above zero and rising fast.

junk bonds negative yields

For the entire universe of European BB-rated bonds (to repeat, these are junk), the average yield is now comparable to what the US pays on 10-year Treasury bonds.

junk bonds negative yields

So why is this happening, and is it as bad as it seems?

The short version of “why” is that when a country borrows too much money, its rising debt slows future growth unacceptably, leading politicians to bully central banks into cutting interest rates further and buying up more assets. Eventually, this process reaches its logical conclusion, which is zero-to-negative interest rates and central bank balance sheets stuffed with assets of laughably low quality. Which is where Europe now finds itself.

And still, the politicians demand more. So rates go negative across the high-quality yield curve (German 10-year paper now yields -.30%), forcing everyone who needs income to move into junkier assets. And voila, high-yield starts trading like Treasuries.

As for why that’s bad, well, let’s count the ways. First, it funnels cheap capital into companies that by definition don’t deserve it, which results in “malinvestment” on a vast scale. Second, it starves pension funds and retirees that need income, forcing them to take on ever-higher degrees of risk.

Combine massive misallocation of capital with excessive risk-taking by investors who don’t understand risk, and the result is an epic crash when junk borrower cash flows inevitably disappoint.

Why do investors put up with it? Saturday’s Wall Street Journal offers a chilling explanation:
One euro junk bond from U.S. packaging company Ball Corp, for example, trades at a yield of minus 0.2% and matures in December 2020. That compares to a European deposit rate of minus 0.4% or a yield on a German government bond with a similar maturity of about minus 0.7%. 
The choice for investors is about the balance between needing to stay invested and how much risk to take, according to Tim Winstone, a fixed-income portfolio manager at Janus Henderson. A bond like Ball Corp’s is “a safe place to hang out,” Mr. Winstone said. “And just because something is negative-yielding, that doesn’t mean it can’t get more negative-yielding.” Falling yields mean rising bond prices and gains for investors, at least on paper. 
Many expect more bond yields to go negative as central banks in the U.S. and Europe cut interest rates or return to bond-buying to stimulate economies. In Europe especially, investors are realizing that negative interest rates are going to last a long time because the ECB needs to overshoot its inflation target to make up for the long spell when inflation has been far below 2%. Without a period of higher inflation, it won’t meet its target on average over the medium term. 
The number of junk-rated companies with negative-yielding bonds will definitely go up, according to Barnaby Martin, credit strategist at Bank of America Merrill Lynch. “It doesn’t take much for it to go from 14 companies to 30 or 50 or 100,” he said.

In other words, investors are now extrapolating falling interest rates into the future and playing junk bonds for the capital gains they’ll generate when their future borrowing costs go down. This is one of those sentiment shifts that financial historians will single out for special attention when sifting through the rubble of the coming crash.

Hating the Fed Is as American as Apple Pie

The tone of Trump’s attacks is new even if the sentiment isn’t. But try living without a central bank.

By Justin Lahart

The tension between Fed Chairman Jerome Powell and President Trump has ample precedents, starting with differences between Treasury Secretary Alexander Hamilton, who proposed the first U.S. central bank, and then-Congressman James Madison, who disliked the concept. Photo: Photo Illustration by Emil Lendof/The Wall Street Journal; Photos: Getty Images

When President Trump complains about the Federal Reserve, he’s taking part in a tradition of central-bank bashing that stretches back to America’s founding. But for all the missteps the Fed has made over the years, the country is better off with it than it would be without it.

Mr. Trump has made no secret of his disdain for its policies. During his election campaign he said the central bank’s stance was too easy, fueling “a big, fat, ugly bubble.” Now he argues the Fed raised rates by too much last year, and has repeatedly called for it to cut them. On Tuesday he suggested he could consider demoting Fed Chairman Jerome Powell.

Mr. Trump is publicly criticizing the Fed in a way no U.S. president has before. But he is also tapping into a longstanding animus toward central banking in the U.S., the power of which shouldn’t be discounted. Investors who take the Fed and the independence it has achieved for granted may need to brush up on their history.

That history begins in 1790, when Treasury Secretary Alexander Hamilton submitted his proposal for the Bank of the United States. Modeled after the Bank of England, it would provide loans to the public and private sectors, and the notes it issued would provide a uniform paper money for business transactions.

Virginia Rep. James Madison and Secretary of State Thomas Jefferson tried to block Mr. Hamilton’s plan, saying it was unconstitutional for the government to set up a bank. Their opposition also arose in part from the prevailing attitude of the agricultural South and of farmers, who tend to be debtors and often detest banks. It was a populist theme that would be repeated.

President George Washington sided with Mr. Hamilton, and the bank was chartered in 1791. But antibank forces continued to pound away, and its charter was allowed to expire in 1811. After five rocky years for the economy, the Second Bank of the United States was chartered with then-President Madison’s support. But two decades later, that charter wasn’t renewed, squelched by President Andrew Jackson.

Starting in 1836, the U.S. stood out as a major country without a central bank. “And then we had a period characterized by financial instability and a much worse track record than any of the European economies,” explains Michael Bordo, an economic historian at Rutgers University. Booms and busts came rapidly, and a series of crippling financial crises culminated in the panic of 1907, the severity of which was a powerful argument for a central bank. Against stiff opposition, the Federal Reserve was set up in 1913.

The years since have, with some notable exceptions, been better. The economy swung far less erratically than before, experiencing far fewer financial crises. And as the Fed has gained more independence, insulating it from politicians’ desire to juice the economy ahead of elections, it has become a more credible steward of the economy.

But when the Fed slips up, or when times get rough, America’s old animus for central banks isn’t far away. The worst it got in recent memory was probably in the early 1980s, when the Fed under Chairman Paul Volcker tightened policy massively to crush inflation, buckling the economy in the process. Now he is widely hailed, but at the time he was getting attacked by both the right and the left. Unhappy home builders sent him two-by-fours pleading for lower rates, even as President Ronald Reagan largely held his tongue.

A board mailed to Fed Chairman Paul Volcker as part of a protest by builders over high interest rates, on display in the 2013 exhibition "The Fed at 100" at the Museum of American Finance in New York. Photo: STAN HONDA/AFP/Getty Images

The 2008 financial crisis also did heavy and justified damage to the Fed’s credibility, since it horribly misjudged the risks that built up during the housing bubble. The unconventional policies it subsequently adopted to combat the recession were also viewed as a massive overreach by critics who were convinced the Fed put the economy at risk of currency debasement and inflation.

Other countries celebrate their central banks: For its 300th anniversary in 1968, Sweden’s Riksbank established the Nobel Prize in economics, and the Bank of England’s tricentennial in 1994 culminated with a service of thanksgiving attended by the Queen. The Fed initially wanted to make an event of its centenary in 2013 but wisely opted for a quiet affair.

Mr. Trump can find sympathy beyond his populist base for threatening the Fed’s independence—after all, it expresses a sentiment that has spanned the political spectrum. Even some financially sophisticated people who should know better wouldn’t mind. They should know better.

Fiscal Money Can Make or Break the Euro

The parallel payment system that Greece's government proposed in 2015 would have bolstered the eurozone. By contrast, the Italian government's planned "mini-Treasury bills" would lead to the single currency's demise.

Yanis Varoufakis


ATHENS – It’s a curious feeling to watch your plan being deployed to do the opposite of what you intended. And that’s the feeling I’ve had since learning that Italy’s government is planning a variant of the fiscal money that I proposed for Greece in 2015.

My idea was to establish a tax-backed digital payment system to create fiscal space in eurozone countries that needed it, like Greece and Italy. The Italian plan, by contrast, would use a parallel payment system to break up the eurozone.

Under my proposal, each tax file number, belonging to individuals or firms, would be automatically provided with a Treasury Account (TA) and a PIN number with which to transfer funds from one TA to another, or back to the state.

One way TAs would be credited was by paying arrears into them. Taxpayers owed money by the state could opt for part or all of those arrears to be paid into their TA immediately, instead of waiting for months to be paid normally. That way, multiple arrears could be eliminated at once, thus liberating liquidity across the economy.

For example, suppose Company A is owed €1 million ($1.1 million) by the state, while owing €30,000 to an employee and another €500,000 to Company B. Suppose also that the employee and Company B owe, respectively, €10,000 and €200,000 in taxes to the state. If the €1 million is credited by the state to Company A’s TA, and Company A pays the employee and Company B via the system, the latter will be able to settle their tax arrears. At least €740,000 in arrears will have been eliminated in one fell swoop.

Individuals or firms could also acquire TA credits by purchasing them directly, via web-banking, from the state. The state would make it worth their while by offering buyers significant tax discounts (a €1 credit purchased today could extinguish taxes of, say, €1.10 a year from now). In essence, a new dis-intermediated (middlemen-free) public debt market would emerge, allowing the state to borrow small, medium, and large sums from the private sector in exchange for tax discounts.

When I first discussed the idea, staunch defenders of the status quo immediately challenged the legality of the proposed system, arguing that it violated the treaties establishing the euro as the sole legal tender. Expert advice that I had received, however, indicated that the system passed legal muster. A eurozone member state’s treasury has the authority to issue debt instruments at will, and to accept them in lieu of taxes. It is also perfectly legal for private entities to trade among themselves in any token they choose (say, frequent flier miles). The line of illegality would be crossed only if the government compelled vendors to accept the digital credits as payment – something I never intended.

An altogether different reaction to my proposal came from those who wanted to end the euro as a single currency, but not necessarily as a common currency. A former chief economist of a major European bank looked at my proposals and recognized in them his own scheme for a parallel currency that Italy, Greece, and other distressed eurozone members would use to pay salaries and pensions. I replied that a parallel currency was both undesirable and pointless, as it would lead to a sharp devaluation of the new national currency, in which most people would be paid, while private and public debts would remain euro-denominated. That would be a recipe for serial, accelerating insolvencies, inevitably leading to the eurozone’s demise.

Then there were those who argued that an announcement of any parallel payment system would trigger a bank run and capital flight, thus pushing the country surreptitiously out of the eurozone, regardless of its intentions. This conjecture contains an important truth: the payment system I proposed would reduce the costs of a euro exit by clearing a rocky but navigable path to a new national currency.

Indeed, if my parallel, euro-denominated system had been operational in June 2015, when the European Central Bank closed down Greece’s banks to blackmail its people and government into accepting the third bailout loan, two outcomes would have been possible. First, transactions would have shifted massively from the banking system to our TA-based public payment system, thus reducing substantially the ECB’s leverage. Second, it would be common knowledge that, at the push of a button, the government could convert the new euro-denominated payment system into a new currency.

Would such a system have triggered a redenomination from the euro to the drachma? Or would it have given pause to the troika of Greece’s lenders (the European Commission, the International Monetary Fund, and the ECB), causing them to think twice before they closed down Greece’s banks and issued their Grexit threats?

The answer depends on the politics of both sides. In this sense, the parallel payment system is neutral: it can be used to bolster the eurozone just as effectively as it can be deployed to break it up.

In our case, the idea was to keep Greece viably within the eurozone by using the additional bargaining power afforded by the parallel payment system to negotiate the deep debt restructuring needed to revive economic growth and ensure long-term fiscal sustainability. As long as our creditors saw that our redenomination costs were lowered, while our demands for debt restructuring were sensible, they would think twice before threatening us with Grexit. Joint action by the ECB and my ministry would allow the parallel system to be portrayed as a new pillar of the euro, thus quashing any financial panic. By ending the popular association of the euro with permanent stagnation, the parallel system would be the single currency’s friend.

This brings us to Italy. There are two technical differences between the system I designed and Italy’s planned mini-Treasury bills (or mini-BOTs). First, mini-BOTs will be printed on paper, something I opposed, to avoid a grey market. Our total supply of digital credits would have been managed by a distributed ledger, to ensure full transparency and prevent the inflationary overproduction of credits. Second, the mini-BOTs will be interest-free, perpetual bonds, without future tax discounts.

But the real difference between the Italian scheme and mine remains political. The parallel payment system I proposed was designed to use the reality of lower eurozone exit costs to create new fiscal space and help civilize the monetary union in the process. Italy’s system is the first step toward a parallel currency by which to bring about the eurozone’s end.

Yanis Varoufakis, a former finance minister of Greece, is Professor of Economics at the University of Athens.

Texas and California

Texafornia dreaming

America’s future will be written in the two mega-states

IN THE CABLE-NEWS version of America, the president sits in the White House issuing commands that transform the nation. Life is not like that. In the real version of America many of the biggest political choices are made not in Washington but by the states—and by two of them in particular.

Texas and California are the biggest, brashest, most important states in the union, each equally convinced that it is the future. For the past few decades they have been heading in opposite directions, creating an experiment that reveals whether America works better as a low-tax, low-regulation place in which government makes little provision for its citizens (Texas), or as a high-tax, highly regulated one in which it is the government’s role to tackle problems, such as climate change, that might ordinarily be considered the job of the federal government (California). Given the long-running political dysfunction in Washington, the results will determine what sort of country America becomes almost as much as the victor of the next presidential election Will.

That is partly a function of size. One in five Americans calls Texas or California home. By 2050 one in four will. Over the past 20 years the two states have created a third of new jobs in America. Their economic heft rivals whole countries’. Were they nations, Texas would be the tenth-largest, ahead of Canada by GDP. California would be fifth, right behind Germany.

Texas and California are also already living America’s demographic future. Hispanics are around 40% of the two states’ populations, double the national average. Both states were early to become majority-minority. In California non-whites have outnumbered whites since 2000, and in Texas since 2005. The rest of the country is not expected to reach this threshold until the middle of the century. California and Texas educate nearly a quarter of American children, many of them poor and non-native English-speakers. Their proximity to Mexico, a country that both used to be a part of, means that as Washington procrastinates on updating America’s immigration laws they must live with the consequences.

At first glance the two states seem as different as a quinoa burger and beef brisket. California is a one-party state in which elected Republicans may soon need the kind of protection afforded to the bighorn sheep. In Texas Republicans dominate the state legislature and all the statewide executive offices: no Democrat has won a statewide race there for more than 20 years. The last Democratic presidential candidate to do so was elected over 40 years ago. Texas has no state income tax. California’s state income tax has a top rate of 13%, the highest in the union. Texas has loose environmental regulations. California is trying to use its economic might to force the rest of the country to adopt more stringent standards on carbon-dioxide emissions. Texas lets its cities sprawl; California has restrictive planning laws.

Take a closer look, though, and Texas looks more like a teenage California. The population of Texas has only recently reached the level California was at in the late 1980s. The Golden State was once a pro-sprawl, low-tax, Republican state, too. Republicans in Austin, who are feeling the first signs of political competition from Democrats in decades, have begun to focus their attention on the state’s shortcomings such as education.

That matters because Texas’s schools, like California’s, perform poorly and its universities are nowhere near as good. In the Texas legislative session which ended last month, politicians focused less on abortion and bathrooms for transgender people, and instead increased funding for public schools. If more Texans managed to vote, they might encourage politicians to do something about the state’s skimpy health-care provision, too.

This might suggest that, as Texas grows up, it will become more Californian. But, ideally, only to a degree—because California has not aged gracefully. It loses Americans each year while Texas gains them. Though the state government has made huge strides—a decade ago it was broke, now it has a healthy surplus and an overflowing rainy-day fund—the state has daunting social problems. Homelessness is just the most visible of them. Unemployment is persistently higher and incomes are more unequal in California than in the land of the ten-gallon hat.

California thinks of itself as a progressive bastion, but it has the highest poverty rate of any state in America. That is partly because regulation makes it so hard to build new homes, pushing housing costs up. It will take more than Google investing $1bn in Bay Area housing to fix that. Texas, meanwhile, lets its cities march outwards as far as they wish. In this limited respect at least, Texas is the more liberal state and California the more conservative one. Americans wanting to move to where housing is cheap, taxes low and work plentiful are voting with their U-Haul trucks and heading to Texas. Just now, Texas has more room than California to innovate and to strike a balance between small government and social support.

In America’s federal system no single state is a national template, and yet each holds lessons for all the others. As America’s largest oil producer, Texas is exceptional. By contrast, despite its faults, California remains a magnet for highly educated migrants and a formidable factory of talent and ideas—which is why it has produced Google, Facebook, Tesla, Uber and Netflix and why, despite grumblings about creeping socialism, the big venture-capital firms and Hollywood studios stay.

America can learn from both of them. That is especially true when the federal government cannot legislate—which today means most of the time—because the ability of states to decide their own fate becomes correspondingly more important.

It is possible to imagine a mash-up of the two mega-states that takes the best of both: a freedom-loving wish to keep government out of people’s private lives, a place that is friendly to business and provides opportunities for people, while also protecting the environment and funding education. California could steal Texas’s expansive approach to housebuilding; Texas could imitate California’s investment in outstanding universities. Americans elsewhere might be less alarmed by demographic change if they visited great cities like Houston, LA and Dallas. Call this imagined place Texafornia.

US-China contest centres on race for 5G domination

A report for the Pentagon warns the US is falling behind China in telecoms

Henny Sender

Less than 10 years ago, all top 10 technology companies by revenue were American. Global telecom standards were set by US companies such as AT&T and Verizon. Today, by contrast, four of the top 10 internet firms are Chinese.

A decade ago, Huawei, the leading Chinese telecoms equipment maker, was a little known provider of services largely to south-east Asia, and eastern and central Europe, rather than a rival to the Americans in more developed markets. Its revenues amounted to some $28bn in 2009. Last year they reached $107bn.

Friction between the US and China, which seemed to have its origins in trade disputes, has moved on. Today telecoms and wireless technology are at the forefront of the competitive sparring between the two countries.

In a world where everything is dual-use technology, it is increasingly hard to distinguish what is commercial and civilian and what is strategic and military. And technology, unlike trade, does not easily lend itself to concessions at the negotiating table. To have the technological edge is existential for both countries.

“There is an even bigger long-term risk facing the world economy than the current trade war. That is the very negative implications of the current US stance against Huawei,” notes Chris Wood, equity strategist for Jefferies in Hong Kong. “The origin of America’s ultra-aggressive stance remains a determination that China will not dominate in 5G or other emerging technologies.”

Yet if no less a source than the Defense Innovation Board, launched in 2016 to help bring innovation and independent advice to the Pentagon, is to be believed, the US is behind in developing the latest technology and in setting global standards for 5G. That is according to an assessment of the prospects of the two national giants in a report on the 5G Ecosystem the board released in April.

The report portrays a technological world in which the US, far from dominating, is in danger of becoming ever more marginal. “The country that owns 5G will own many innovations and set the standards for the rest of the world. That country is currently not likely to be the United States,” the report concludes starkly. “Chinese equipment is cheaper (and) in many cases is superior to its western rivals.”

One Chinese venture capitalist says he takes this as an affirmation that “we won”.

The introduction of 5G is a big deal, both in itself and because of its multiplier effect on a range of other technologies including autonomous vehicles, the internet of things, smart cities, virtual reality and, battlefields, whether physical or in cyber space. The companies or countries that are the first movers will set global standards. That in turn brings hundreds of billions of dollars in revenues, substantial job creation and leadership in any other technologies that require ever swifter transmission of data, the board notes.

“In the early 2010s, AT&T and Verizon took the lead in rapidly deploying next generation technology that improved on 3G technology. US companies like Apple, Google, Facebook, Amazon, and Netflix then built new applications and services . . . and helped drive global US dominance in wireless and internet services,” it states.

Today, though, the US has lost its edge when it comes to telecoms technology for reasons that have little to do with any possible predatory behaviour either from Beijing or Huawei, which today has become a national champion of China, in part because of attacks from the White House and Congress.

Part of the problem is lack of investment. China has spent $180bn over the past five years and has 10 times as many base stations as the US. American companies including Verizon and AT&T have too much debt to undertake the huge investment necessary to build out the numbers of base stations required, the report notes, while other western firms, such as Nokia and Ericsson, have also seen their fortunes decline.

Another obstacle is the fact that in the US, the government and the military appropriate most of the spectrum being used by the rest of the world for commercial purposes, leaving the US market isolated. By themselves, the US markets, both civilian and military, are no longer big enough to dictate to others or to prevent Chinese 5G from continuing to increase market share globally.

The larger question of course is whether what is true in telecoms becomes true on a wider scale.

Meanwhile, the effect of any US sanctions against Huawei or others is likely to only accelerate Beijing’s efforts to achieve self-sufficiency.