A negative bond yield is when an investor receives less money at the bond's maturity than the original purchase price for the bond. A negative bond yield is an unusual situation in which issuers of debt are paid to borrow.
In other words, the depositors, or buyers of bonds, are effectively paying the bond issuer a net amount at maturity instead of earning a return through interest income.
Understanding Negative Bond Yields
Bonds are debt instruments typically issued by corporations and governments to raise money. Investors purchase the bonds at their face value, which is the principal amount invested.
In return, investors typically get paid an interest rate—called the coupon rate—for holding the bond. Each bond has a maturity date, which is when the investor gets paid back the principal amount that was initially invested or the face value of the bond.
Bonds that have been previously issued and sold by investors before the maturity trade on the secondary market called the bond market. Bond prices rise and fall depending on various economic and monetary conditions in an economy.
The initial price of a bond is usually its face value, which could be $100 or $1,000 per bond. However, the bond market could price the bond differently depending on a number of factors, which could include economic conditions, the supply and demand for bonds, the length of time until expiration, and the credit quality of the issuing entity. As a result, an investor might not receive the face value of the bond when they sell it.
Typically, an investor might buy a bond at a $95, for example, and receive the $100 face value at maturity. In other words, the investor would've bought the bond at a discount ($95) to the face value ($100). Negative yielding bonds would result in an investor receiving less back at maturity, meaning an investor might pay $102 for the bond and get back $100 at maturity. However, the coupon rate or interest rate paid by the bond also plays into whether the bond is negative-yielding.
Bonds trading in the open market can effectively carry a negative bond yield if the price of the bond trades at a sufficient premium. Remember that a bond's price moves inversely with its yield or interest rate; the higher the price of a bond, the lower the yield.
The reason for the inverse relationship between price and yield is due, in part, to bonds being fixed-rate investments. Investors might sell their bonds if it's expected that interest rates will rise in the coming months and opt for the higher-rate bonds later on.
Conversely, bond investors might buy bonds, driving the prices higher, if they believe interest rates will fall in the future because existing fixed-rate bonds will have a higher rate or yield. In other words, when bond prices are rising, investors expect lower rates in the market, which increases demand for previously-issued fixed-rate bonds because of their higher yields. At some point, the price of a bond can increase sufficiently to imply a negative yield for the purchaser.
Why Investors Buy Negative Yielding Bonds?
Investors that are interested in buying negative-yielding bonds include central banks, insurance companies, and pension funds, as well as retail investors. However, there are various distinct reasons for the purchase of negative-yielding bonds.
Asset Allocation and Pledged Assets
Many hedge funds and investment firms that manage mutual funds must meet certain requirements, including asset allocation. Asset allocation means that the investments within the fund must have a portion allocated to bonds to help create a diverse portfolio.
Allocating a portion of a portfolio to bonds is designed to reduce or hedge the risk of loss from other investments, such as equities. As a result, these funds must own bonds, even if the financial return is negative.
Bonds are often used to pledge as collateral for financing and as a result, need to be held regardless of their price or yield.
Currency Gain and Deflation Risk
Some investors believe they can still make money even with negative yields. For example, foreign investors might believe the currency's exchange rate will rise, which would offset the negative bond yield.
In other words, a foreign investor would convert their investment to a country's currency when buying the government bond and convert the currency back to the investor's local currency when selling the bond. The investor would have a gain or loss merely from the currency exchange fluctuation, irrespective of the yield and price of the bond investment.
Domestically, investors might expect a period of deflation, or lower prices in the economy, which would allow them to make money by using their savings to buy more goods and services.
Safe Haven Assets
Investors might also be interested in negative bond yields if the loss is less than it would be with another investment. In times of economic uncertainty, many investors rush to buy bonds because they're considered safe-haven investments. These purchases are called the flight-to-safety-trade in the bond market.
During such a time, investors might accept a negative-yielding bond because the negative yield might be far less of a loss than a potential double-digit percentage loss in the equity markets. For example, Japanese Government Bonds (JGB) are popular safe-haven assets for international investors and have, at times, paid a negative yield.
Example of a Negative Bond Yield
Below is an example of two bonds, one of which earns income while the other is negative-yielding by the time of the bond's maturity.
Bond ABC has the following financial attributes:
Maturity date of four years
Face value of $100
Coupon interest rate of 5%
Bond price for $105
Bond ABC was purchased for a premium, meaning the price of $105 was higher than its face value of $100 to be paid at maturity. At the onset, the bond might be considered negative-yielding or a loss for the investor. However, we must include the bond's coupon rate of 5% per year or $5 to the investor.
So, although the investor paid an extra $5 for the bond initially, the $20 in coupon payments ($5 per year for four years) create a $15 net profit or a positive yield.
Bond XYZ has the following financial attributes:
Maturity date of four years
Face value of $100
Coupon interest rate of 0%
Bond price for $106
Bond XYZ was also purchased for a premium, meaning the price of $106 was higher than its face value of $100 to be paid at maturity. However, the bond's coupon rate of 0% per year makes the bond negative-yielding. In other words, if investors hold the bond until maturity, they'll lose $6 ($106-$100).
The $6 loss translates to a 6% loss in percentage terms, and when spread out over the four years, it equates to a negative-yield of -1.5% (-6% / 4 years) annually.