As an investor, it is counter-intuitive that negative interest rate investment instruments exist; even more so that investment funds would even consider buying them. But they do exist, and it is estimated that over $16.5 trillion in negative yielding bonds are in circulation. The question is, why do they exist and what is their appeal?
Negative interest bonds are exactly what their name suggests. They are bonds that offer investors negative interest rates on their investment. This essentially means that that the value of the bond will be less when it matures that when it was bought. So, investors all-but-pay to own the asset.
Negative interest-bearing bonds made their appearance during the 2008 financial crisis. Sweden’s Riksbank was the first Central bank to venture into negative interest territory, with Japan and other European countries following suit shortly thereafter.
Low, and now negative interest rates are tools used by central banks to stimulate economies. The strategy is that the unattractive interest rate environment will force investors to invest in asset classes other than cash, which is ultimately a way to channel capital into assets that can grow the economy. And the data suggests it works. Historical economic data has shown that Japanese and European bourses have benefitted from bond yields dropping below zero.
This environment then has a knock-on effect. As bond rates fall, central banks also reduce their lending rate to commercial and retail banks, which encourages them to drop the interest rates offered to customers. As business and retail lending rates fall, borrowing increases. This means that business can lend more for capital expenditure projects, and consumers can afford to spend more money in terms of home loans, car loans, and credit card debt. All this spending ultimately drives growth within the economy.
Making money on negative-yielding bonds
The question is, however, why are investment firms buying into negative rate products when they are guaranteed to lose money. In the markets, this is a widely debated issue with thought leaders sitting on both sides of the fence. It’s believed that many investors buy into negative interest bonds without consideration of the interest rates because they form part of a well-diversified strategy with the bonds reducing the risk of the overall strategy.
Bagholders are people who hold investments in securities that decrease in value. In this instance, investors may expect the value of the negative-yielding bonds to keep rising. For example, the European Central Bank could start its repurchasing programme, meaning they will snap up issued bonds. So, although the bonds are negative yielding, the cost can potentially be offset if the security’s price rises.
2. Safe assets
Many investors believe that negative-yielding bonds are some of the best instruments to weather economic storms caused by geo-political tensions and financial disasters. Their negative value is outweighed by their ability to with withstand market distress.
3. Cross-currency hedging
United States fund managers are paid to hedge against currency fluctuations. As such, they often hold negative-yielding European and Japanese bonds as the returns from currency movements might make up for any loss in bond yields.
4. Yield curve values
Investors who buy bonds and sell them before they mature, may make money on the difference in yield curves. If the interest rates for shorter term bonds is more negative than longer-term bonds, then there is to money to made on the transaction.
Although negative-yielding bonds seem an odd investment, there are instances where the experienced investor can come out in the black from the investment. It is not a universally agreed strategy, but for whatever the reason, with $16.5 trillion negative-yielding bonds in circulation, investors are certainly buying into the asset.