March 13, 2015    3 minute read

The Rationale Behind Negative Yields

The Rationale Behind Negative Yields

The news is that there are trillions of dollars in bonds that have negative yield. Of course, borrowing costs are supposed to be positive, otherwise the potential lender would be better off keeping the money in their pocket. So what is rationale behind negative yields?

The Deflation Game

Consider a bond that returns -0.2% but inflation is also negative, i.e. -0.3%, then the real return on the aforementioned investment is still positive and equal to +0.1%. Said differently, this is a way to profit from deflation.

One could point out that even if it is possible to make money from this kind of deal, it is still better off to keep the money in cash. Whilst it may remain true, cash in not exactly free. There are other costs that are incurred with physical cash including insurance as well as expenditures to protect the banknotes (vault, security and so forth).

The Currency Game

Even though the Bund has negative yield, it is still a Euro-denominated asset. So if someone expects an appreciation of the Euro against other currencies, he may think to buy a Bund to benefit from this supposed increase in the value of the European currency.

The caveat to such an argument is that if somebody wants to profit from a possible appreciation of the Euro, then they would be better off buying Euro-denominated assets, which have a positive yield, like Italian, Spanish or French bonds. That is true, however some investors may not want to have exposure to sovereign risk, which Germany does not bear to the same level as that of Italy and Spain.

Avoiding the Charge on Deposits

Since June 2014, the ECB has introduced a 0.2% “tax” on the excess of liquidity of banks. The aim of such a measure is to encourage financial institutions to provide money to households and firms – stimulating the economy. However, this rule may be bypassed. Many banks, instead of granting loans, prefer to park the excess liquidity in safe assets with short duration such as the 5-year Bund. It is still convenient: the Bund yields -0.1% but the tax is equal to 0.2%, so they are saving 0.1% in costs.

Reverting to National Currency

Suppose the Euro ceases to exist and European countries revert back to their former currencies. In this case the Euro-denominated Bund will be converted into a debenture, which pays coupons and principal in the Deutsche Mark. This is a very remote scenario, however, in such an extraordinary event, investors would most certainly prefer to have bonds that pay in Deutsche Marks, when compared with Pesetas.

All in all, perhaps the most reasonably argumentation is the avoidance on the charge on deposits. Banks do not want to grant loans, so the most viable option for them is to buy a negative yielding Bund, which entails fewer costs compared to the charge to pay the ECB on deposits.

The negative yield world is of course an abnormal circumstance. It is damaging for financial institutions, as they experience compressed interest margins and earnings. It is troublesome for investors, who may be discouraged to invest due to the yield-starved environment. Such an environment fosters the search of higher return, which drives people to put their money in riskier financial products. Given the level reached by US equity market, this may not be only speculation.

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