Gold makes sense in a world of negative yields

Yields are turning negative, but gold still has its appeal

I said here last week that I couldn’t imagine not holding some gold in today’s increasingly odd financial environment. It isn’t exactly the first time I’ve said it. But it is the first time I haven’t had much of a response from readers.

Usually I get a pile of emails telling me how ludicrous it is to suggest as an investment something that you effectively have to pay to hold. Gold pays no dividends or interest and you have to store it somewhere, so changes in its capital value aside, the very act of holding it costs you something every day. That, say those who don’t much fancy gold, is completely ridiculous.

The thing is that it doesn’t look quite as ridiculous today as it did even a year ago. The base interest rate in Denmark and in Switzerland is currently negative — you pay to get the central banks to hold your money — and the FT reproduced a chart from JPMorgan last week showing the value of outstanding European government bonds that have a negative yield.

the FT reproduced a chartBack in June 2014 that number was negligible. Now it is over €1.5trn. And this isn’t just a Europe thing: Japan auctioned bonds with a negative yield for the first time late last year. Let’s have a closer look at this. The words ‘negative yield’ are bandied about in the bond market these days as though they made perfect sense.

They don’t. Clearly if we were to use words as they are meant to be used, there would be no such thing as a ‘negative yield’. But we are in the world of finance here. So let’s have a look at what the words are actually used to mean in this context. Let’s assume first that we are talking about zero-coupon bonds. These don’t pay interest, but are issued at one price and redeemed at another.

Normally the redemption price is the higher. So you could sell a one-year bond at 95.23p and redeem it at 100p, making the effective interest rate (yield) on it about 5%. But if you sold the bond for 101p and redeemed it at 100p, you would have created a bond with a negative yield of 1%. Holding it for a year costs investors 1p per bond.

Bonds that offer a conventional rate of interest or ‘coupon’ when first offered can also end up with a negative yield. If their price goes higher than their face value (the amount you get back when the bond is repaid) plus the cumulative value of the interest payments still to come, again it costs you actual cash to hold it for its full term. That too is referred to as a negative yield.

You will be wondering who on earth would be idiot enough to pay to buy this stuff. Well, Mario Draghi for starters: he was very clear last week that his quantitative easing (QE) programme doesn’t rule out buying bonds with negative yields. But he clearly isn’t alone in this: think like a trader and buying bonds such as these makes a crazy kind of sense. Because if interest rates go even lower, the yields on the bonds will become more negative and the price of the bonds rise even further. You might lose on the interest front, but in the short term, you could make some capital gains.

I can hear your horror. That’s not investing, you say. Ignoring income in the hope of making only capital gains is just gambling on the ‘greater fool’ theory. You’re right, of course. But while this seemingly insane behaviour is new to the bond market, we have long experience of it in other markets. Remember the dotcom bubble, when everyone bought stocks with no actual income on the basis that the capital gains would more than compensate them for their costs of investing?

And what of the UK property market? Most buy-to-let investors I meet tell me they expect all their profit to come from capital gains: even with rates this low, it’s hard for the mortgaged to make a real return from their rents. The same goes surely for the foreigners buying up London property at the moment.

Let’s say you buy a super smart two-bedroomed flat in “award winning riverside development” St George’s Wharf in Vauxhall. The best ones, apparently, cost £4m, but the more workaday ones will hit you for a mere £2m. The rent seems to be in the region of £5,000 a month, a gross yield of about 3%.

But then there are the service charges. Given the “extraordinary level of service” available to residents and provided by “internationally renowned Harrods Estates Asset Management”, these don’t come cheap: think £9.25 per square foot in this case, or some £10,000 a year. The yield is now 2.5%.

Factor in the occasional void period; council tax; and some renovations (tenants in this kind of property don’t like wear and tear) and you could easily end up paying to own the thing.

Have a mortgage and you definitely will. If you treat the flat as a safety deposit box and never rent it out, you will incur a minimum negative yield of 0.5% — the service charge as a percentage of the value of the flat. That’s rather worse than the yield on Swiss or German bonds, but much the same price as a bank currently pays to hold money at the Danish National Bank.

The point here is that paying to hold an asset in the hope that it will either keep most of your capital safe or offer you a greater fool gain is a perfectly well established investment strategy in today’s very odd investing environment. But if I am going to pay to hold something, I’d rather it was some portable lumps of yellow stuff than IOUs from a modern government — or a identikit flat in an area which was once best known for its ugly and dangerous gyratory, but which has recently been rebranded as ‘prime central London‘.

• This article was first published in the Financial Times.

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