What Is a Negative Bond Yield?
A negative bond yield occurs when an investor receives less money at the bond’s maturity than the original purchase price. Essentially, in this unusual scenario, issuers of debt are paid to borrow money.
In simpler terms, buyers of these bonds are effectively paying the issuer at maturity instead of earning a return through interest income.
Key Takeaways
- A negative bond yield means an investor gets back less at maturity than they initially paid.
- Even after factoring in interest payments, a negative-yielding bond indicates a net loss at maturity.
- Such bonds are often purchased as safe-haven assets during times of economic uncertainty and also for portfolio asset allocation by large funds.
Unlocking the Mysteries of Negative Bond Yields
Bonds, as debt instruments, are typically issued by corporations and governments to raise funds. Investors purchase these bonds at their face value, which is the principal amount invested.
In return, they earn an interest rate—known as the coupon rate—for holding the bond. Each bond has its maturity date, a point at which the principal amount or face value is repaid to the investor.
Bond Valuation
Bonds released and resold by investors prior to their maturity are traded on the secondary market, called the bond market. Bond prices fluctuate based on various economic and monetary conditions.
The initial price of a bond is typically its face value, such as $100 or $1,000 per bond. However, several factors such as economic conditions, supply and demand, bond maturity length, and the credit quality of the issuer can impact bond prices, leading to instances where a bond might sell for higher or lower prices.
For instance, an investor might buy a bond for $95 and receive the $100 face value at maturity, effectively buying at a discount. Conversely, with negative-yielding bonds, an investor could pay $102 and get back only $100 at maturity, incurring a loss despite any interest payments received.
Diving Into Bond Yields
Bonds traded in the open market can develop a negative bond yield if the bond trades at a high enough premium. It’s critical to note that bond prices and their yields move inversely—meaning the higher the price of the bond, the lower the yield.
This inverse relationship is partially due to bonds being fixed-rate investments. Investors might part with their bonds if they anticipate rising interest rates in the coming months, to take advantage of higher-rate bonds later on. Conversely, investor demand for bonds with higher fixed rates might rise if they expect future interest rates to drop, thus driving bond prices upward and potentially hitting the threshold for a negative yield.
Why Negatively-Yielding Bonds Still Find Buyers
Despite the ostensibly unappealing prospect of negative yields, there are critical reasons why these bonds attract investors such as central banks, insurance companies, and pension funds.
Diversity in Asset Allocation and Pledged Assets
Investment firms managing large portfolios often must meet specific asset allocation requirements, ensuring a portion is allocated to bonds to maintain a diversified and balanced portfolio. These bonds help hedge against losses from other investments.
Further, bonds are frequently used as collateral for financing, necessitating their possession regardless of returns.
Betting on Currency Gains and Deflation
Some investors bank on profiting from currency exchange rate fluctuations rather than bond yields. By exchanging into a favorable currency when buying a bond and back to their native currency upon selling, they manage to offset the bond’s negative returns.
Domestically, bettors on deflation expect lower future prices, which increases the purchasing power of savings—even if those savings experienced a nominal loss.
Seeking Safe Haven Assets
During times of economic uncertainty, many investors gravitate towards bonds, viewing them as safe-haven investments. This flight-to-safety often justifies accepting slight losses to avoid larger potential hits to equity investments.
Illustrative Example of Negative Bond Yields
To flesh out the concept, consider two bonds—one yielding profit and the other yielding a loss.
Bond ABC:
- Maturity: 4 years
- Face Value: $100
- Coupon Interest Rate: 5%
- Purchase Price: $105
Initially bought at a premium ($105 vs. $100), Bond ABC might seem negative yielding. Yet with 5% annual coupon payments, totaling $20 over four years, the net gain stands at $15.
Bond XYZ:
- Maturity: 4 years
- Face Value: $100
- Coupon Interest Rate: 0%
- Purchase Price: $106
While Bond XYZ is also bought at a premium ($106 vs. $100), the 0% coupon rate renders it negative-yielding. Holding until maturity results in a $6 loss, equating to a -1.5% annual yield over four years.
Related Terms: Coupon Rate, Face Value, Safe Haven Assets.
