Absurdonomics: Negative Bond Yields

By Mikael Fevang.

Let me begin with a short explanation of bonds and what they are. A bond is a loan not too dissimilar to a “standard” bank loan, with a major difference being that no periodical down payments are made during the bond’s duration. Instead, the debtor pays interest only (“the coupon”) to its creditors until the bond reaches its “maturity date” – the date of which the initial loan sum (“the principal”) is to be repaid in full to the current holders of the bond. Thus, a £100 ten-year bond with a 5% yearly coupon means that any investors can expect £5 annually for ten years, with full repayment of their £100 (i.e., the principal) at the end of that period.

In addition, bonds are freely transactable between investors – similar to equities. This creates a market for bonds, and the price of a bond can fluctuate above or below its issuance price. As such, because the coupon and principal have fixed values, the “yield” (i.e., the return on money invested) can be calculated. This yield is inversely related to the market price of the bond with a higher price indicating a lower yield and vice versa.

A negative yield illustrates that a bond is trading at a price so much higher than its par (principal) value that even when accounting for both the future coupon payments and the return of the principal, the investor still buys the bond at a net cost. So, what is it that is causing investors to invest in something that is expected to cost – rather than reward – money? To understand this, it is important to appreciate the fact that bonds (in their state-issued form) are considered to be one of the safest investments one can make. Even in times of dire recession and war, a state is expected to continue paying coupons and returning principals to its investors. Sovereign bonds are considered by many to be safer than bank deposits. As such, sovereign bonds often form the reliable backbone of both public and private finances.

There are multiple possible answers to the question of why, but the most convincing ones are macroeconomic and geopolitical in nature.

The geopolitical side of the argument is that investors are increasingly worried about the uncertainty dominating national politics and global relationships. Sino-US relationships are deteriorating; the EU is facing a multitude of internal disputes with Brexit as the cherry on top, and the situation in Kashmir is at its most precarious in decades. And these are just the tip of the iceberg. The potential for conflict and sudden changes to the international structure is high, causing risk-averse investors to actively seek safe harbours for their money.

At the moment, it would seem that the market judges the geopolitical risk to be so high that even paying a premium to have your money looked after by the state is a good investment.

The macroeconomic side of the argument is that most of the western world, especially Europe, is still struggling with slow growth following the 2008 financial crisis. As a result, in an attempt to stimulate spending and lending, the European Central Bank (ECB) imposed a negative interest rate for deposits back in 2014. However, this has not had the desired effect it wanted; rather, the ECB has had to lower the interest rate further, causing an increasing number of European banks to charge negative interest on the deposits of their biggest depositors, as well as on loans to their debtors. For example, in the case of mortgages, the mortgagor (the borrower) must make interest payments to the bank. However, when the interest becomes negative, the reversal happens and the bank has to pay interest to the borrower. This absurd phenomenon is increasingly being observed in Denmark, with both mortgagors and corporate borrowers being paid simply because they have an outstanding loan balance with their bank. Charging people who save and paying those who borrow is becoming the new norm.

Although negatively yielding bonds have existed for almost a decade since the 2008 financial crisis, the current prevalence of them is unprecedented, with a third of the global bond markets ($17 trillion worth) offering negative yields. Investors seem to be increasingly pessimistic about the future, and as such, they flock to bonds at such a rate that yields are being pushed into the negatives. What has always been considered a low-risk way of making a small return is turning into a safety deposit box charging a fee. “Panic” would describe the situation nicely.

The situation is absurd and will likely remain so until geopolitical risk factors and macroeconomic weaknesses have been resolved. Considering the rising political tensions and continued existence of deep policy fracture points, resolution and compromise seem depressingly distant. As cliché as it is, these are very interesting times.

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