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 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. below par rate, say, $98, and the value of the security moves back to par value at maturity $100. With 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 par value of $ 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,yYield At Maturity,yYield 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 expected returns after making all the payments on time throughout the life of a bond. 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, 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., EURIBOR. For e.g.. if 3 months EURIBOREURIBORThe Euro Interbank Offer Rate (Euribor) is the interest rate at which European Union banks lend funds to each other. It is a daily changing benchmark and reference interest rate that includes terms ranging from a week to a year. is currently trading at -.020,% means spread below 20 basis points will require payments which are not possible, so below 3 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 is required to pay upfront cost similar to the option to protect from negative yield,d, 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..
#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 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., 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. 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. (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 marketMoney MarketThe money market is a market where institutions and traders trade short-term and open-ended funds. It enables borrowers to readily meet finance requirements through any financial asset that can be readily converted into money, providing an organization with a high level of liquidity and transferability. 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
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 a 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 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). 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 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). turns negative. Domestic investors buy their own government yield bonds if a prolonged period of deflationDeflationDeflation is a decrease in the prices of goods and services caused by negative inflation (below 0%). It usually results in increased consumer purchasing power, owing to a simple supply and demand rule in which excess supply leads to lower prices. 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 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. 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 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 leads to huge 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. 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 the 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 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., collateralized loan obligations that offset the negative yield of government bond 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.
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 –