In uncertain markets, investors often seek fixed income for the relative safety that bonds provide versus riskier assets like equities. But with interest rates declining since the 80s, bond yields have come under pressure, even falling below zero in some markets. Led by Japan and Europe, about 27% of the global bond market trades at yield below zero according to Bloomberg. What are negative-yielding bonds? Here’s what happens when bond yields go negative.
Key factors that affect bond yields
Central banks use monetary policy to support economic growth
In 2014, the European Central Bank (ECB) was the first major central bank to lower a key interest rate into negative territory. Essentially, the goal was to stimulate economic growth by lowering the cost of debt to stimulate borrowing. Simultaneously, banks were penalized for holding too much cash at negative rates.
In 2020, the Federal Reserve stepped in to support the economy during the Covid-19 pandemic by setting the target Federal Funds rate to zero. While it’s widely believed that the Federal Reserve wouldn’t follow the European Central Bank in setting below zero target rates, that doesn’t mean bond yields can’t go negative. When demand raises prices, yields go down.
The relationship between bond prices, interest rates, and bond yields
Bond prices move inversely to interest rates. As interest rates rise, bond prices decline. If rates decline, bond prices will increase. Bond prices also move inversely to yields, so as prices rise, yields go down.
Increasing demand for bonds raises the price, which reduces an investor’s expected return—the yield. The current yield is the return a buyer could expect if they hold the bond for a year. The current yield is calculated as the bond’s annual income, divided by the current price.
Demand for bonds depends on many factors, but generally, if investors want safety from riskier assets like stocks, they may turn to bonds instead, driving up prices. Interest rates also affect the demand for bonds. If you buy a bond when interest rates are 5%, and the next day rates drop to 4%, all else equal, someone would pay a premium for your bond versus a newer bond.
How can a bond have a negative yield?
When yields go negative, investors don’t actually pay the issuer. The premium is the difference between the purchase price and the par value of the bond. If the premium exceeds the income the investor will receive during their holding period, the yield will be negative.
If you agreed to give a friend $105 in exchange for $100 in two years, and the friend pays $2/year in interest, you’d have a negative yield. The $5 premium you paid is more than the $4 you earned in interest.
Here’s another simplified example of how negative yields typically work. An investor buys a bond that matures in three years for $103 when the par value is $100. The bond does not pay a coupon (interest). The par value is what the investor receives when the bond matures. If the investor holds the bond to maturity, the yield is -.98%.
Why would anyone buy negative-yielding bonds?
The U.S. may not be accustomed to negative yielding bonds, but they’re prevalent across Japan and Europe. Individuals invested in ETFs or mutual funds that track an index may end up owning some negative-yielding bonds as part of a broader basket designed to mimic the exposure of a particular market or geographic region.
For some U.S. investors working with a professional money manager, foreign debt may potentially present an investment opportunity through currency hedging premiums, if large enough to offset negative yields.
Yield curves look very different around the world. Shifting rates in the foreign economy relative to the investor’s local economy is a key part of the equation. If another country has a steeper yield curve and there’s a currency premium for U.S. investors, hedging the local currency to the U.S. dollar can provide another component of return.
Nothing is certain in the financial markets
It’s important to note that when an investor buys a bond with a negative yield, it doesn’t automatically mean they’re going to lose money on the investment. Investors only ‘lock in’ the negative yield if they hold the bond until maturity. Otherwise, it’s possible that prices continue to rise if the economic outlook worsens (and yields fall further). This would enable an investor to sell their bond for a premium on what they paid for it. Of course, there’s reinvestment risk, as the investor now has cash and could be forced to reenter the bond market when yields are even lower.
Conversely, if conditions in the economy improve or interest rates rise, investors may want to sell bonds and add risk. When that happens the prices of bonds fall, pushing yields up. An investor who purchased a negative-yielding bond who wishes to sell before maturity could take a loss on the price of the bond, but then go buy another bond with a higher (or positive) yield to maturity.
There are many factors that influence bond markets around the world. Yields vary depending on a number of factors. Credit quality, future expectations of interest rates and inflation, income, duration, type of bond, and the spread relative to safer bonds like treasuries all factor in.
These factors are very fluid. Since the Fed is unlikely to cut rates below zero, the U.S. will likely still have higher yields relative to overseas, though that could always change. Until it does, global bonds offer investors another source of return and diversification as part of a well-balanced asset allocation.
This article was written by Darrow advisor Kristin McKenna, CFP® and originally appeared on Forbes.
This article is for informational purposes only and not to be misinterpreted as personalized advice or a recommendation for any specific investment product, strategy, or financial decision. Both past performance and yields are not reliable indicators of current and future results. This material does not contain sufficient information to support an investment decision. If you have questions about your personal financial situation, consider speaking with a financial advisor.
Article cover page image source: Organization for Economic Co-operation and Development, Long-Term Government Bond Yields: 10-year: Main (Including Benchmark) for Japan [IRLTLT01JPM156N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/IRLTLT01JPM156N, January 14, 2021.