What is the Negative Yield Bond?
A Negative yield bond is when the issuer of the bond (borrowers) is paid by the investor (holder of the bond) to borrow money in a negative interest rate environment. Investors end up losing money when they hold such bonds until maturity. For example, consider an investor who under normal circumstances would buy a zero-coupon bond below par rate say, $98 and the value of the security moves back to par value at maturity $100. With negative yield bond investor buy at a premium price i.e. above par at $103 and during the term, price falls back down to par value $ 100. Negative yield erodes the value of the security in nominal terms.
Types of Negative Yield Bond
The following are types of negative yield bonds.
#1 – Fixed-Rate Bond
If the bond is sold at a negative yield at maturity the buyer does not receive back the total amount invested. The negative yield impacts the maturity value but not the coupon payments as it is not possible to collect negative coupons from the investor.
#2 – Floating Rate Bond
The reference rate paid on floating rate notes can be linked to an index such as OIS, LIBOR, EURIBOR. For e.g. if 3 months EURIBOR is currently trading at -.020% means spread below 20 basis points will require payments which is not possible so below 3 options exist incorporate negative yield:
- Add a large spread at initiation which requires a large upfront payment. This is not so popular as FRN investors prefer to buy at the par rate.
- The negative coupon is netted against early redemption or maturity payment.
- The third option is the floor option. Where the investor is required to pay upfront cost similar to the option to protect from negative yield which will be too expensive.
Reasons Behind the Existence of Negative Interest Rate
The following are the reasons behind the existence of the negative interest rate.
#1 – Action by Central Bank
A central bank implements monetary policy to manage interest rates and money supply in order to target economic growth levels and inflation rates. They also stimulate economic growth by increasing the money supply in the economy and cutting borrowing rates through bond purchases. By nature, the yield is inversely related to bond price i.e. if yield increases bond price falls and vice versa. If the central bank continues to purchase the bond in the market bond prices are pushed higher until rates become negative. So, it can be said that negative yields are a reflection of extremely high prices.
#2 – Regulatory Requirement
May force institutional investor such as central banks (to meet foreign exchange reserves), pension funds (to match liabilities and meet reserve requirement), insurance companies (to meet short term claims of the policyholder), banks (to meet continuous liquidity requirement and in order to borrow fund in money market they need to pledge collateral to keep a portion of fund in a liquid form by buying negative yield bonds). They are constrained by the mandate and rules set aside by different regulators.
#3 – Trade-off Between Liquidity and Return
Buying negative yield bonds is similar to pay the issuer to safeguard your money. There is a trade-off between liquidity and return. The investor does require return but on the other hand, they need to keep a certain portion to meet the liquid requirement of clients in order to facilitate rapid access to cash or cash-like assets. Money market funds in order to invest in the euro government debt market typically hold a bond with 13 years of maturity. Bonds with lesser than this maturity yield negative rates.
#4 – To Deal with Economic Slowdown
Negative yield arises due to challenges faced by central banks with regard to an economic slowdown. Buying a negative yield bond is a signal to remedy deflation. In 2016 slow growth in the global equity market has encouraged investors to shift their allocation from risky assets towards low-risk assets or risk-free assets such as government bonds which lead to an increase in prices to meet higher demands. As demands surge, bond prices continue to increase until the yield curve turns negative. Domestic investors buy their own government yield bonds if a prolonged period of deflation is expected.
#5 – Negative Bonds Regarded as Safe Heavens in Falling Market
There are some investors who believe small losses in the form of negative yield is better than large losses in the form of capital erosion. For example, the European equity market was 20% below the level of their expectations, corporate bonds were defaulting, commodities prices were falling so investors moved to safe heavens assets despite the fact that it provided negative yield during turmoil.
#6 – Currency Speculation
Some foreign investors buy negative yield bonds if they expect it will fetch more profitable returns as compared to other asset class returns. For e.g. some foreign investors were of the view that yen will appreciate in the future and hold negative yield bonds denominated in yen after a certain period yen did jump drastically which leads to huge capital gain from currency appreciation even after accounting for negative yield.
Best Strategies to Deal with Negative Yield Bonds
The following are the best strategies to deal with negative yield bonds.
#1 – Active Investment Strategy
The passive approach involves constructing a portfolio to replicate the returns of bond index whereas an active portfolio approach involves selecting securities based on unique characteristics and their associated correlations which determine how they perform on a consolidated basis to achieve a return that outperforms the index. An active manager can minimize the impact of negative yields by adding value in a bond portfolio to take advantage of a relative basis, tactical opportunity to outperform the broader market.
#2 – Diversification Benefits
An investor can enhance return by diversifying a portfolio across different segments of bonds markets, tenors, sectors, industries, asset class levels such as mortgage-backed bonds, emerging markets, structured products, asset-backed security, collateralized loan obligations that offset negative yield of government bond at an aggregated level. The volatility of one can be used to offset the volatility of other bonds as result return will be higher and risks will be much lower.
Negative yield does involve payment for accepting deposits. Central banks of nine developed countries have set interest rates below zero to deal with deflation.
This has been a guide to what is a negative yield bond. Here we discuss reasons and strategies to deal with negative yield bonds along with its types and example. You can learn more about accounting from the following articles –