One of the questions we’ve been getting a lot lately is why would someone buy a negative yield bond? First, let’s quickly explain what a negative bond is: It is a bond that, when held to maturity, produces a negative yield for the bondholder. Negative-yield bonds are rising in popularity, as the chart below shows:
The amount of negative-yield bonds has doubled to more than $12 trillion since early 2018. To better grasp the concept of negative-yields, let’s look at a few different hypothetical 10-year bonds:
- Bond A with a 4% coupon priced at $100 yields a 4% annualized return when held to maturity.
- Bond B with a 4% coupon priced at $115 yields a 2.31% annualized return when held to maturity.
- Bond C with a 4% coupon priced at $145 yields a negative 0.405% annualized return when held to maturity.
Why would anyone own Bond C?
Well, let’s look at another asset such as an investment property. Is there ever a reason someone might buy an investment property that produces no income? All the property does is costs money in maintenance, taxes, utilities, etc. But what if you also found out that Google was opening an office down the street? Despite the negative cash flow on the investment property, you’d probably expect it to rise in value. Perhaps you buy the property for $250k and you believe it will be worth $350k after Google moves in.
In other words, you’re betting that external circumstances will positively impact the price of your asset. Negative yield bonds are similar. The buyers of negative yield bonds rarely expect to hold the bond to maturity. Rather, they look to buy the bond and sell it later for a higher price. Just like our investment property buyer referenced above.
What might cause a negative bond yield?
So what might influence the price of a bond and cause the yield to turn negative? Well, In September 2019, the European Central Bank (ECB) announced a return to quantitative easing (QE). In other words, the ECB will start buying bonds out of the market with cash. Overall demand for bonds increases with the ECB acting as a huge buyer in the market. In addition, their purchases increase the supply of cash in the market. This is a perfect recipe for higher bond prices and thus, ever-decreasing bond yields.
In addition to QE, some anticipate a strengthening of certain currencies. Currency appreciation will positively impact other assets that are priced in that currency. For example, let’s say an institutional investor converts 1 million USD to 1 million euros. He then buys €1 million worth of negative-yielding German bunds. Six months later, the bund price hasn’t changed, but the euro has risen 10% versus the dollar. The investor sells the bunds and converts his euros back to dollars, capturing a 10% return from currency appreciation.
The bottom line
The bottom line is there can be a number of different reasons why an investor might buy a negative-yielding bond. These include betting on increased demand for the bond itself or anticipating currency appreciation. Other reasons might have to do with the current yield curve and future inflation expectations. We’re not sure how long negative bond yield mania will last, but we wouldn’t expect a sea-change anytime soon.
(P.S. here is an excellent bond calculator to determine yield to maturity and help you see if a bond will post a negative annualized return or not).
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