Negative Yield Bond

Updated on April 8, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Is A 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.

Negative-Yield-Bond

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This type of bond holders receive less money than they had initially invested. Thus, the investors actually pay for lending their money to the issuer. It exists in economic environments where the rates are negative or very low. They are often used in developed countries to combat deflation.

Key Takeaways

  • A negative yield bond is one in which the issuer (borrower) is compensated by the investor (bondholder) for borrowing money in a negative interest rate environment. When investors carry such bonds to maturity, they lose money.
  • Fixed-rate bond and floating rate bond are the types of the negative yield bond.
  • Dealing with negative yield bonds requires active investment strategies and diversification benefits. Negative yield bonds need depositors to pay for their deposits, and nine developed countries’ central banks have set interest rates below zero to address deflation.

Negative Yield Bond Explained

The negative yield bonds are also known as sub-zero yield bonds that gives an yield which is below zero. The investors who invest in them get less amount on maturity than their initial investment. Economy with very low or negative interest rate issue such bonds. In some developed economies, central banks implement unconventional monetary policy to fight deflationary situations using such bonds.

The negative yield on a bond is a challenge for investors because they get less than the initial investment if they continue to hold them till maturity. Investors accept such financial instruments only if they anticipate the yields going further down. Investors considering capital preservation more necessary than returns may invest in such bonds.

It is a very unconventional instrument that only suits some investors. Negative yield does involve payment for accepting deposits. Central banks of nine developed countries have set interest rates below zero to deal with deflation.

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Types

The following are types of negative yield bonds.

Negative Yield Bond Types

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#1 – Fixed-Rate Bond

If the bond is sold at a negative yield at maturity,yYield At Maturity,yThe yield to maturity refers to the expected returns an investor anticipates after keeping the bond intact till the maturity date. In other words, a bond's returns are scheduled after making all the payments on time throughout the life of a bond. Unlike current yield, which measures the present value of the bond, the yield to maturity measures the value of the bond at the end of the term of a bond.read more buyer does not receive back the total amount invested. The negative yield on a bond impacts the maturity valueMaturity ValueMaturity value is the amount to be received on the due date or on the maturity of instrument/security that the investor holds over time. It is calculated by multiplying the principal amount to the compounding interest, further calculated by one plus rate of interest to the period's power.read more but not the coupon payments, as it is impossible to collect negative coupons from the investor.

#2 – Floating Rate Bond

The reference rate paid on floating notes can be linked to an index such as OIS, LIBORLIBORLIBOR Rate (London Interbank Offer) is an estimated rate calculated by averaging out the current interest rate charged by prominent central banks in London as a benchmark rate for financial markets domestically and internationally, where it varies on a day-to-day basis inclined to specific market conditions.read more, or EURIBOR. E.g., if three months EURIBOREURIBOREuribor stands for Euro Interbank Offer Rate, which is the interest rate at which European Union banks lend funds to one another. It is a benchmark and reference interest rate that changes daily and covers tenures ranging from a week to a year. read more is currently trading at -.020,% means spread below 20 basis points will require payments which are not possible, so below three options exist incorporate negative yield:

  • Add a large spread at initiation, n, 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 must pay upfront costs 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 rateNegative Interest RateWhen the interest rate falls below 0 percent, we have a negative interest scenario. This implies that banks will charge you interest for keeping your money with them. It is more common during periods of extreme deflation.read more.

#1 – Action by Central Bank

A central bank implements monetary policyMonetary PolicyMonetary policy refers to the steps taken by a country’s central bank to control the money supply for economic stability. For example, policymakers manipulate money circulation for increasing employment, GDP, price stability by using tools such as interest rates, reserves, bonds, etc.read more to manage interest rates and money supply to target economic growth and inflation rates. They also stimulate economic growth by increasing the money supply and cutting borrowing rates through bond purchases. By nature, the yield is inversely related to bond priceBond PriceThe bond pricing formula calculates the present value of the probable future cash flows, which include coupon payments and the par value, which is the redemption amount at maturity. The yield to maturity (YTM) refers to the rate of interest used to discount future cash flows.read more, 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 investorInstitutional InvestorInstitutional investors are entities that pool money from a variety of investors and individuals to create a large sum that is then handed to investment managers who invest it in a variety of assets, shares, and securities. Banks, NBFCs, mutual funds, pension funds, and hedge funds are all examples.read more such as central banks (to meet foreign exchange reserves), pension fundsPension FundsA pension fund refers to any plan or scheme set up by an employer which generates regular income for employees after their retirement. This pooled contribution from the pension plan is invested conservatively in government securities, blue-chip stocks, and investment-grade bonds to ensure that it generates sufficient returns.read more (to match liabilities and meet reserve requirements), insurance companies (to meet short-term claims of the policyholder), banks (to meet continuous liquidity requirements and to borrow fund in money marketMoney MarketThe money market is a financial market wherein short-term assets and open-ended funds are traded between institutions and traders.read more they need to pledge collateral to keep a portion of the 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

Money market funds 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. Buying negative yield bonds is similar to paying the issuer to safeguard your money. There is a trade-off between liquidity and return. The investor does require a return, but on the other hand, they need to keep a certain portion to meet the liquid requirement of clients to facilitate rapid access to cash or cash-like assets.

#4 – To Deal with Economic Slowdown

Buying a negative yield bond is a signal to remedy deflation.

Negative yield arises due to challenges faced by central banks about an economic slowdown. In 2016 slow growth in the global equity marketEquity MarketAn equity market is a platform that enables the companies to issue their securities to the investors; it also facilitates the further exchange of these stocks between the buyers and sellers. It comprises various stock exchanges like New York Stock Exchange (NYSE).read more encouraged investors to shift their allocation from risky assets towards low-risk or risk-free assets such as government bondsGovernment BondsA government bond is an investment vehicle that allows investors to lend money to the government in return for a steady interest income.read more, which led to increased prices to meet higher demands. Bond prices continue to increase as demands surge until the yield curveYield CurveThe Yield Curve Slope is used to estimate the interest rates and changes in economic activities. It is a plot of bond yields of a particular issuer on the vertical axis (Y-axis) against various tenors/maturities on the horizontal axis (X-axis).read more turns negative. Domestic investors buy their government yield bonds if a prolonged period of deflationDeflationDeflation is defined as an economic condition whereby the prices of goods and services go down constantly with the inflation rate turning negative. The situation generally emerges from the contraction of the money supply in the economy.read more is expected.

#5 – Negative Bonds Regarded as Safe Heavens in Falling Market

Some investors believe small losses in negative yield are better than large losses in the form of capital erosion. For example, the European equity market was 20% below their expectations; corporate bondsCorporate BondsCorporate Bonds are fixed-income securities issued by companies that promise periodic fixed payments. These fixed payments are broken down into two parts: the coupon and the notional or face value.read more were defaulting, and commodities prices were falling, so investors moved to safe heavens assets despite providing negative yield during turmoil.

#6 – Currency Speculation

Some foreign investors buy negative yield bonds if they expect to fetch more profitable returns than other asset-class returns. E.g., For some foreign investors who believed that the yen would appreciate in the future and hold negative yield bonds denominated in yen after a certain period, the yen did jump drastically, which led to massive capital gain from currency appreciationCurrency AppreciationCurrency appreciation is a rise in the value of a national currency over the importance of international currencies due to an increase in the demand for domestic currency in a global market, a rise in inflation and interest rates, and flexibility of fiscal policy or government borrowing.read more even after accounting for negative yield.

Example

Let us go through a negative yield bonds example to understand the concept.

For example, consider an investor who, under normal circumstances, would buy a zero-coupon bondZero-coupon BondIn contrast to a typical coupon-bearing bond, a zero-coupon bond (also known as a Pure Discount Bond or Accrual Bond) is a bond that is issued at a discount to its par value and does not pay periodic interest. In other words, the annual implied interest payment is included into the face value of the bond, which is paid at maturity. As a result, this bond has only one return: the payment of the nominal value at maturity.read more below par rate, say, $98, and the security value moves back to par value at maturity of $100. With a negative yield, bond investors buy at a premium price, i.e., above par at $103, and during the term, the price falls back down to a par value of $ 100. A negative yield erodes the value of the security in nominal terms. Thus, the above negative yield bonds example explains the concept.

Strategies

The following are the best strategies to deal with negative yield bonds.

Best Strategies to Deal with Negative Yield Bonds

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#1 – Active Investment Strategy

The passive approach involves constructing a portfolio to replicate the returns of the bond index. In contrast, 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 to 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, and asset class levelsAsset Class LevelsAssets are classified into various classes based on their type, purpose, or the basis of return or markets. Fixed assets, equity (equity investments, equity-linked savings schemes), real estate, commodities (gold, silver, bronze), cash and cash equivalents, derivatives (equity, bonds, debt), and alternative investments such as hedge funds and bitcoins are examples.read more such as mortgage-backed bonds, emerging markets, structured productsStructured ProductsStructured products in Finance refer to a set of two or more assets or securities with a combination of an interest rate and single or multiple derivatives. These pre-packaged investments may include traditional financial instruments, such as equities, options, investment-grade bonds, indices, commodities, mutual funds, exchange-traded funds, or currency pairs, with non-traditional payoffs.read more, asset-backed securityAsset-backed SecurityAsset-backed Securities (ABS) is an umbrella term used to refer to a kind of security that derives its value from a pool of assets, such as bonds, home loans, car loans, or even credit card payments.read more, collateralized loan obligations that offset the negative yield of government bonds at an aggregated level. The volatility of one can be used to offset the volatility of other bonds. As a result, the return will be higher, and the risks will be much lower.

Frequently Asked Questions (FAQs)

Why invest in negative yield bonds?

Even when the coupon rate or interest rate paid by the bond is included, a negative-yielding bond indicates the holder loses money at maturity. As a result, negative-yielding bonds are acquired as safe-haven investments during times of instability and by pension and hedge fund managers for asset allocation.

Why do negative yield bonds exist?

Since during an era of extraordinarily low-interest rates, many major institutional investors were ready to pay more than face value for high-quality bonds. As a result, they were willing to accept a negative return on investment in exchange for the security and liquidity provided by high-quality government and corporate bonds.

Who invests in negative yield bonds?

Central banks, insurance companies, pension funds, and individual investors are all interested in acquiring negative-yielding bonds.

How do negative yields impact financial markets and institutions?

Negative yields can affect financial markets by distorting pricing and investment decisions. Financial institutions, such as banks and insurers, may need help generating returns on their investment portfolios and managing liabilities.

This has been a guide to what is a Negative Yield Bond. We explain it with examples, its types, reasons for its existence, and strategies. You can learn more about accounting from the following articles –

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