On March 10th, the ECB announced its plan to stimulate the economy. This includes increasing quantitative easing (QE), incentivising banks to increase their lending and an even lower interest rate. The ECB cut interest rates to -0.4 per cent. They also eased the impact on private banks with cheaper short-term loans at a negative interest rate, paying Eurozone private banks to increase credit to individuals and companies. The ECB will now buy €80bn (instead of the previous €60bn) worth of bonds monthly. This is going to significantly affect bond yields. But how?
The yield is the return on the bond. All bonds trade at a price, which is inversely related to its yield. In simple terms, if a bond price rises, the yield falls and vice versa. This yield is referred to as yield-to-maturity (YTM). YTM is the rate of return an investor can expect if the bond is held until maturity. Let’s look at an example:
Bond price: $100, Coupon rate: 5%
Bond market price: $80, Years to maturity: 5 years
Currently, the YTM for the bond with market price $80 is 10.3%. However, the higher the demand for an asset, the greater its perceived value (which is reflected in its market price). As the ECB ramps up its buying, the bond prices continue to increase. Continuing with the example, if the market price increases to $150, the YTM falls to -3.87%. This is nothing new – there are many bonds out there trading at a negative yield. In fact, around 7 trillion USD worth of bonds have a yield below zero. However, it will be interesting to see the magnitude of the implication of the ECB’s recent move.
In the example, the yield fell to -3.87%. This means that if an investor bought the bond at $150 and held it to maturity, the investor incur a loss. This raises a question – why would one invest in a negative yield bond?
“It feels counter-intuitive…You invest in something and you already know the return will be negative.”
Joost Beaumont, strategist at ABN Amro
Negative yield bonds are fairly popular. Many European countries already have bonds trading at negative yields (a few countries have more than 50% of their bonds trading sub-zero). It’s not just Europe – Japan also has such bonds. Recently, German bank Berlin Hyp issued its first sub-zero non-state bond – this is the first time the yield has been negative at the time of issue. So, why would investors invest in something that is guaranteed to make them a loss if they hold to maturity?
Reasons for Investing in Negative Yields
- Investors could be aiming for a capital gain. This means that they want to sell the bond for higher than the price initially paid.
- Security. Although they have negative yields, bonds are still considered safe, and some investors prefer losing a known amount of money in the safety of bonds than losing an unknown amount in an uncertain asset.
- Better options. For banks, a negative bond yield might be a better rate than negative deposit rates at other banks.
- Buying foreign bonds. For example, Japanese bonds are sold in yen. European investors will invest in these bonds if they think the yen is going to appreciate. A big currency gain would more than offset the negative yield.
- Deflation expectations. Domestic investors could buy government’s negative-yielding bonds if they expected a prolonged period of deflation. Although the negative yield would result in a nominal loss, the deflation would offset that and result in a positive real return.
Some of these reasons raise cause for concern. Buying foreign bonds implies that investors expect their domestic currency to depreciate and having deflation expectations implies that investors expect lower GDP growth. This is inconsistent with the ECB’s goal. The aim of the QE and the lower interest rates is to stimulate growth — the investors are hoping for the exact opposite so that they can make money. This could lead to problems down the road because investors will make large bets right now, hoping for deflation. However, if the ECB’s stimulus package works, then those investors will incur heavy losses (unless they hedge their current bets) and this can lead to an unpleasant business environment in the future.
To conclude, negative rates are an interesting phenomenon about which not much is known. Initially, investing seems counter-intuitive. However, there are a few good reasons to buy such bonds. But it also seems to create a conflict of interest between the ECB and the Eurozone investors.