Why Would Anyone Buy a Bond with a Negative Yield?
Historically, purchasing a bond as an investment was simple and straightforward: An investor purchased a bond, received interest payments based on the coupon rate of that bond over the stated term, and then at the bond’s maturity the owner receives a return of his original principal. While market interest rates can be volatile and do go up and down over time, sometimes dramatically as they did in the early 1980s, bond yields have always tended to be positive. That seems like an obvious requirement, as the whole point of investing in a bond, or any investment for that matter, is to earn a positive return on your invested funds.
In the current financial market environment, interest rates in the U.S. are very low. The 10-year U.S. Treasury bond, the benchmark bond for most fixed income investors, today trades at a yield of 1.88 percent. While that yield is historically low, we must consider the current inflation rate in our economy, of about 1.9 percent. Interest rates and the rate of inflation typically go hand in hand, as the inflation rate is a very important consideration for a bond investor. Bond prices and yields move up and down with the rate of inflation, as it would not make much sense for a bond investor to purchase a bond yielding 2 percent if the inflation rate is 5 percent. That investor would reap 2 percent a year from his bond, but the value of his currency would depreciate by 5 percent during that year, leaving him with a net loss of 3 percent. While there is not a direct formulaic relationship between inflation and bond yields, it makes logical sense that their general movements are linked.
Likewise, if a bank makes a mortgage loan to a homebuyer, that mortgage interest rate also needs to be above the rate of inflation. The bank would not lend money to a homebuyer at 4 percent if the inflation rate sat at 7 percent. The bank would earn 4 percent on the loan, but the currency would depreciate by 7 percent, giving the bank a net loss of 3 percent. So, it is logical that interest rates across the fixed income spectrum, from government bonds to mortgage rates to corporate bond yields would move up and down depending on the prevailing rate of inflation.
It is also logical for investors to ponder, “Why would anyone invest in a bond with a negative yield?”. This issue has arisen given the recent state of economic affairs in Europe, as many countries have issued government bonds with a negative yield. And that means exactly what you think it means, that an investor purchases a bond knowing that he will get back less than his original investment. Today, nearly $17 trillion of negative-yielding bonds trade around the world and investors in these countries continue to purchase new issues. These negative yield bonds have increased in demand amid global economic concerns and easier monetary policy by central banks.
Although investors buying bonds with subzero interest rates are, in effect, paying for the privilege to hold on to an investment, that cost can be more than offset if the security’s price rises. Investors who scoop up negative-yielding bonds are betting that the value of the securities will keep rising. In effect, they are wagering that other investors will pay more for these bonds tomorrow, months or years from today. With the European Central Bank widely expected to restart their asset purchasing program, European bond-buyers could be relying on the central bank to buy up their portfolios of negative-yielding securities.
In July, an auction for 4 billion Euros of 10-year German government bonds sold at a negative yield of 0.26%, but the bond has risen in price since then. Therefore, the investors who bought debt at that auction have reaped a gain of around 4% from the price increase of the bond alone. Investors lose a little from the negative yield on the bond but are hoping to make up for this loss as the price of the bond rises. It may be considered a risky bet, but investors globally are making that bet.
Why are governments issuing debt with a negative yield? Because European economies are growing very slowly and teetering on recession, and inflation is anemic. Governments are in effect saying “Do not keep your money in bank accounts or invest it in bonds. We want you to loan it out to business owners who will then make investments to grow the economy. Or you can spend it. Or use your money to buy stocks in order to boost asset prices and the economy. Or start a business yourself. We need you to invest or spend this money to grow the economy.”
In addition to issuing bonds with negative yields, European governments and the European Central Bank are also printing money and using that money to buy bonds. This increases the demand for bonds, pushing bond prices up and yields down even further. This “Quantitative Easing” is also a signal to investors that holding cash is not a good idea.
While negative yield bond investors are taking a risk, betting that bond prices will continue to increase making bond yields fall further, that bet is being made by intelligent people who are assuming this risk with their eyes open. And the reasons for issuing negative yield bonds are clear and understandable, as governments want investors to use their investment capital to stimulate the economy rather than keeping it in cash or bonds. However, given that European economic growth continues to be sluggish and inflation very low, these efforts to spur growth with negative yield bonds do not seem to be very effective so far. These are strange times, indeed.
