Ice Cream All Round

December 3, 2019

By Dr. George Calhoun
Executive Director of the Hanlon Financial System Center

Dr. George Calhoun, professor of quantitative finance at Stevens Institute of Technology and the Executive Director of the Hanlon Financial Systems Center at Stevens, penned the below article. As a member of Research Advisory Board at Hanlon Investment Management, Dr. Calhoun works in conjunction with Hanlon on investment research. His latest article, titled Ice Cream All Round, explores the disconnect between risk and yield currently occurring in global government bond markets.

Something funny — actually not so funny – is taking place in the Bond Markets.

Exhibit 1

In September, Italy was able to sell 10-year government bonds yielding 0.88%.1 In Europe – where, for example, all of Germany’s bonds then traded at negative yields – this is considered attractive, and the offering was oversubscribed.2 “Lo Spread” – the ominous gap between Italian and German bond yields that serves as a proxy for the economic angst in Italy – has eased to half what it was a year ago. Party-time in Rome, or, as Bloomberg puts it:

Italy is the only large liquid government market in Europe with any juice
left… It’s ice cream all round and in theory every reason to load up
further on bonds that yield something. Anything.3

Meanwhile, the yield on 10-year Treasury bonds backed by the full faith and credit of the United States stands at 1.8%.

Now, Italy is in a multi-year recession. Real GDP has not grown in two decades.4 Unemployment is 10%. Public debt is 134% of GDP.5 Debt service costs are the highest in Europe. Italy’s credit is rated just above Junk. And yet – the Italian Government (almost an oxymoron after its “collapse” earlier this year) has to pay only half as much as the US Treasury to raise money from supposedly savvy bond investors.

Exhibit 2

Speaking of Junk, and oxymorons – some Junk Bonds now carry negative yields.6

Euro-Dominated Corporate Bonds

Yes, that sentence is correct. “High Yield” can now mean “Negative Yield.” Fourteen BB-rated corporate bonds were trading in negative territory as of July. The context is an increasing fragile market: European securities regulators warn that 40% ofhigh yield bond funds “would not have enough liquid assets available to meet investor withdrawals in the event of a market shock.”7

Exhibit 3

Back to Europe, and 2012. Greece then was on the edge of insolvency, its 10-year bonds yielding almost 37%. Things have improved, but the IMF’s latest assessment remains guarded.

Long-term debt sustainability is not assured… Greece [is] vulnerable to a
range of external and domestic shocks.”8

The country’s credit rating today is B1 – “highly speculative” – reflecting an 11% chance of default within 3 years, and 22% over 10 years. And yet – the current yield on Greek 10-year bonds is 1.37%.

On October 9, 2019 Greece sold 3-month debt with a negative yield.

Three explanations are on offer: Stupidity, Greed, and Macroeconomics.

Some say that investors are simply under-estimating the credit risk inherent in these instruments. Stupidity.

Others blame the “something, anything” crowd, who may understand that the credit risk is priced incorrectly, but who are so desperate for yield that they bid up the prices beyond all reason.9 Greed.

Other analysts argue that the valuations are actually reasonable, reflecting, say, “demographic shifts,” or a “savings glut + scarcity of high quality bonds,” or changes in pension fund regulations, or deflation, or “Japanification,” or maybe something else. The New Normal, and all that.

All these explanations cling to the idea that the markets really do measure credit risk. The yields are (supposedly, temporarily…) distorted by external interference – say, investor exuberance, or unconventional monetary policy.

These arguments fail in two ways. First, it is obvious that the default probability for Greek debt, say, is so much higher than for US Treasury Bonds that we cannot view the discrepancy as merely a “mispricing.” Yield no longer tracks credit risk.

Moody's Credit Ratings

The second fail is more confounding. The Equilibrium Principle, which is supposed to be the beating heart of any financial market (and of classical economic theory, for that matter), isn’t pumping. If the US debt yields 1.8% and Italian debt yields 0.88% – on that basis alone, who would buy Italian debt when they could buy Treasurys and double their return? All the more so if we take currency risk into account (the Euro is expected to weaken against the Dollar).

Where then are the fabled arbitrageurs of Finance Theory? They should be selling Buoni to buy Treasurys, raising US prices, lowering US yield, and driving prices and yields in the opposite direction for Italian debt… until the “correct” price for each country’s credit risk is reached.

That is not happening. Price-insensitive trading is a growing trend in the equity markets, fueled by indexing, ETFs, high frequency trading, and share buybacks, where buy/sell decisions are increasingly driven by considerations other than the enterprisevalue signal that share prices are supposed to portray. The same thing is happening now in the bond world. The price of credit risk has disappeared from the market’s calculation.10

So, what drives bond yields today? We’re still figuring that out. Is yield simply a new sort of derivative – with central bank policy as the “underlying”? A way to play the Fed, or to play the people who play the Fed? Or is yield a meaningless metric in a market characterized by shortages of “safe assets” (as Central Banks gobble them up)? Or has a carnival spirit simply taken hold in the market, setting up another game of musical chairs, for lesser and greater fools?

But this we know. In the stock market, bubbles begin and end with shifts in psychology and sentiment, which can be powerful but not imperative. Strong-stomached investors may go against the trend, or simply wait out the storm. With bonds, decisions become compulsory. Debt must be serviced. Loans come due. Credit risk is real. Default is real. Ice cream melts.

1 Tommy Stubbington, “Italy Sells €7.5bn Debt at Record Low Funding Costs,” The Financial Times, September 28, 2019. Italian 10-years have traded recently at yields as low as 0.76%.
2 All recent Italian bond offerings have been massively oversubscribed – e.g., Tyler Durden, “Record Demand For 5x Oversubscribed 30Y Italian Bond Despite Recession,” 2019-02-06/record-demand-5x-oversubscribed-30y-italian-bond-despite-recession
3 Marcus Ashworth, “The Bond Market Is Heading for Fun in the Sun,” Bloomberg, July 29, 2019
4 JamesMackintosh, “No Roman Holiday For Investors in Italy,” The Wall Street Journal, December 6, 2016.
5 The highest in Europe (except for Greece).
6 Paul J. Davies, “Oxymoron Alert: Some ‘High Yield’ Bonds Go Negative,” The Wall Street Journal, July 14, 2019; Laura Benitez and Tasos Vossos, “Sub-Zero Yields Start Taking Hold in Europe’s Junk-Bond Market,” Bloomberg, July 9, 2019. Available online at: —These articles are based on research done by Bank of America Merrill Lynch.
7 Chris Flood, “ESMA Warns on Bond Fund Liquidity Risk,” The Financial Times, September 9, 2019.
8 Lefteris Papadimas and Renee Maltezou, “In uphill battle, Greece needs lower fiscal targets- IMF,” Reuters, September 27, 2019.
9 Chris Flood, “Negative Yields” Investment Chiefs Weigh In on a Potential Bond Bubble,” The Financial Times, September 9, 2019.
10 Tommy Stubbington, “Signs of Certainty: Safe Assets in Short Supply as Centra Banks Buy Big,” The Financial Times, November 19, 2019.