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Question of the Week - February 9, 2015

Guest Post - Monday, February 09, 2015

How does a bond end up with a 'negative' yield?

No doubt, you've read about this happening with certain European debt recently, notably Swiss long-term bonds (which ended last week still trading at a -0.11% yield). How is this possible and why does it happen? In short, it's all in the math.

Bond yields can be quoted in several different ways. For example, we purchase a newly issued 10-year note, at par, with a stated coupon of 2.0%. By par, we mean we buy the bond at '100,' or its base value. This keeps things standardized, whether we're discussing increments of $1,000 or $25 million. We can then expect the bond to pay us $2 in interest/year per $100 in principal value. If interest rates remain at that same 2.0% level for the next 10 years (unlikely, but simplifies the example), we will continue to earn 2.0% per year and receive our $100 back at maturity. Therefore, our coupon yield and yield-to-maturity both equal 2.0%.

We can then complicate things a bit. Based on history, we know that interest rates are likely to change, and change dramatically, over this 10-year period. If rates end up rising to 3.0% in the first year, for example, this 2.0% coupon-paying bond will no longer look as attractive as higher-paying newly-issued 3's, so its price will drop according to its lower level of attractiveness. Mathematically, it should fall to the point where the combination of its 2.0% coupon and accretion of its discount back to par will equal the 3.0% earned by the other bonds (so, with 9 years remaining, its price might fall to about $920 or so). The $80 discount between the price paid by a buyer at that time and full $100 received back at maturity is included in the investor's total return, so the yield-to-maturity becomes the needed 3.0%. (This can also happen in reverse when interest rates fall, when a premium turns into a capital loss essentially, although it's not called that for tax purposes.)

We now complicate things further. If conditions exist such as investors feeling extremely risk averse, bond supplies tightening or deflation fears taking hold, demand for certain bonds could rise dramatically—this often happens to treasury debt of certain countries, but could happen to other bonds as well. In fact, demand could rise to the point where buyers will pay a significant premium to buy any bonds they can get their hands on. This might be 'artificial' demand from central banks in conjunction with government policy efforts, commercial banks needing certain defined types of collateral or reserves, index funds that have to buy whatever is contained in a particular index, those looking for short-term arbitrage or trading opportunities in certain assets or currency plays, or investors so safety-conscious or deflation-weary that this negative result is outweighed by other needs. Governments, large pensions and other institutional investors are too large to play in the FDIC-insured online savings account and CD market like retail investors can, so their 'safe' asset choices can be limited.

Back to the math involved—there is typically still a coupon, but it isn't large enough to offset the high price paid for the bond. In this sense, the yield is again a byproduct of the price paid; no one usually goes hunting around for negative yields as a first choice. In an extension of the same bond example, assume rates fall dramatically during that first year. That 2.0%-paying bond could become so attractive to buyers at that point in relative terms that its price would rise from par to around, say, $1,200. So, with the coupon and the associated amortization of that -$200 premium needing to happen over the next 9 years as the bond matures at its regular $100 value (it can't mature for more than that!), the resulting yield-to-maturity turns into a negative -0.25%. That's how it can happen.

Note that negative bond yields are different from negative bank deposit rates. That's a unique animal completely, and implies that instead of member banks earning interest on reserves held at central banks, they would need to pay the central bank a fee to hold funds there. Of course, this is quite unusual, but it's happening now in Europe as well. Why? It's about incentives. If a bank is forced to pay a fee, it would probably rather move its money elsewhere where it can actually earn something, such as through loans or other investments—hence, the exact rationale for a central bank implementing such a get money out and working in the economy.

There is one last element to this, and that's the concept of the negative 'real' rate—the yield after inflation is considered. Negative real rates happen a lot more frequently than do negative nominal rates, and can persist. In fact, if you haven't noticed, it's been happening in the U.S., as the 3-month Treasury yield of just over 0%, minus trailing inflation, gets us to about -0.75% in real yield...implying investors aren't keeping up with inflation through cash investments. Real yields tend to be at least marginally positive historically, becoming more strongly positive (over 2% typically) at the longer end of the yield curve where money is tied up for longer periods of time and subject to more uncertainty in conditions and policy over 10-30 years. Even there, real yields have been at very low levels in recent years.

This isn't to say such a situation can't persist for a while, but at low nominal yields and even lower real yields, there isn't a lot of reward being provided in traditional fixed income these days.

Additional Reading

Read our Weekly Review for February 9, 2015.

Read the previous Question of the Week for January 19, 2015.

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