Why Negative Yield on Bonds is Rising?

What are these negative yield bonds? Why do people invest in such bonds? All other answers to the bonds are here.

The Bonds

What would you do when you need money? You will either sell your belongings or borrow it. When companies or governments borrow money from people, they do it using an instrument called 'bond.' Bond is a security issued by companies or governments that mentions that they are borrowing a certain sum from you for a specified period. Once this period is over, they will return you the money. During this period, they will keep paying you a certain amount as interest. This amount is called as 'coupon.'

Hence, the bond is governed by a few variables. The coupon rate or negative interest rate, the period of bond or maturity period, and the amount one gets at maturity.

The Yield of a Bond

The amount of coupon payment received for the price of a bond is called 'yield.' The amount one gets at maturity and all the coupons received during the period together for the price of a bond is called as 'Yield to Maturity.'

Yield = Coupon Amount/ Bond Price

Assume you buy a Rs. 100 bond. You will receive Rs. 5 as a coupon every year. Therefore, the current yield shall become 5/100 = 0.05.

On the other hand, suppose you are promised that on maturity, you will get Rs.  100 back. The maturity period is ten years. Therefore, by coupon rate of Rs. 5 per year, you will get Rs.  50 as total coupons. (For simplicity, we will ignore changes in the value of money because of time)

Hence, by the end of 10 years, you get Rs.  100 (maturity amount) and Rs.  50 (coupon payments). Thus, you receive Rs.  150 in 10 years. Since you were promised Rs. 100 at maturity, the bond price at maturity is Rs.  100. Therefore, the yield is 150/100 = 1.5.

A negative yield is when this yield falls below 1.

However, for a simplistic understanding of the concept, we will see yield as the amount received (irrespective of bond price). It means the YTM in the previous example will be Rs.  150. The negative yield will be when the investor's final yield is below zero.

The Interest Rate vs. Bond Price

You have Rs. 100 with you. Say banks offer you an 8% interest rate, and bonds offer you a 5% coupon rate. What will you prefer? Most sane people would go for the higher interest rate option. If the coupon rate were higher than the interest rate, most people would have preferred the bond.

Suppose you by the bond at a 5% coupon rate. Sometime later, banks lower their interest rates to 4%. Now, though people would get cheaper loans, depositors will not get enough interest. They would wish if they could have their bond that gives a higher coupon rate. The demand for your bond has increased. Its price will also increase. People would come to you offering Rs.  125 for your bond.

You may sell the bond today at a higher price and let go of further coupons, or you may hold it until maturity, sell it at promised price and enjoy its coupons. This is how you realize the benefits of the bond.

The Negative Interest Rates

In recent times, Japan and European central banks have reduced their interest rates below zero. This means that if you take a loan of Rs. 100 and interest rate is -1%, you will have to repay only Rs.  99. They hope that negative interest rates would spur demand. However, this also means that if you deposit Rs. 100 with the bank and bank interest rate is -1%, you will get back only Rs. 99.

Nobody wants to lose money. People started looking for other investment options. One such option is government bonds. The government itself backs government bonds. Though no investment in the world is safe, government bonds are considered as risk-free. When we say the investment is more or less risky, it is always said considering that government bonds have zero risks. This is rightly so. After all, in cases where the government was on the verge of default, it printed more money to repay the debt. This has its own problems, but you will get back the money.

The Negative Yield Bonds

In recent times when the interest rates have fallen below zero, people are running after bonds that have higher coupon rates. As explained above, people would offer more prices for the same bonds.

One more thing we should remember. In cases of Yield to Maturity, we saw that the final yield is some of all coupons received and the maturity amount.

Let us assume that the negative interest rate in the country is -1%. You have a Rs. 100 bond that will pay a coupon of Rs. 5 per year for the next 10 years (5% coupon rate) and Rs. 120 at maturity amount.

The Yield to Maturity will be:

YTM = Coupons for 10 years + Maturity Amount

         = Rs. 5 x 10 + Rs. 120

         = Rs. 50 + Rs. 120 = Rs.  170

Hence, the final yield of the bond is Rs. 170.

Say a person comes and offers you Rs. 150 for the bond. In this case, he would still get a Rs. 20 profit. However, what would happen if someone buys this bond at Rs. 200? In this case, he would incur a loss at the end of 10 years. His yield would be negative, Rs. 30. This is a negative yield!

Why People Buy Negative Yield Bonds?

This was not an intention in the first place. With negative interest rates elsewhere, the demand for positive coupon rated bonds soared high. It rose so high that people actually paid a higher price than they deserved. This is the reason that within 4 years, we have $17 trillion valued negative yield bonds.

When central banks reduced repo rates, the coupon rates on bonds also came down (Bonds have to be competitive with the banks). This affected Pension Funds the most. Pension funds, banks, and other organizations that are bound to put their money in government bonds owing to safety (as told they are risk-free) had to buy government bonds at a very high price. They had no option but to invest in negative yield bonds.

Sometimes, foreign investors buy these bonds hoping that the currency will appreciate. In that case, returns from rise in the currency will offset reduced output from bonds.

Domestically, in developed countries, people might think that if deflation (inflation rate goes below 0%) happens, they will make some money.

The Consequences

The Negative Bond Yields will cause a lot of problems. With negative interest rates and repo rates, people are losing their money. They would stop investing money and rather prefer to hoard it. This would cause a blow to economic activities. The economy will be severely affected because nobody wants to lose money.

Investors in these countries have already started looking for some other avenues to invest. Canada's Ontario State Pension Fund has relaxed its laws so that they may invest in National Infrastructure Investment Fund (NIIF) of India. Japan is investing in India's Mumbai-Ahmedabad Bullet Train Corridor, and other infrastructure projects in Africa. Australia is planning a similar project in Bangladesh and Vietnam. This is all leading to 'Capital flight' in these countries.

The negative bond yield is not yet a problem for India, but investor readers must understand the consequence of following the herd. Overpaying the actual price will be detrimental. As Ben Graham says in his book, 'The Intelligent Investor,' "…we need to separate investors from speculators."