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Posted by: Deepa Vasudevan on Mon, Sep 9th, 2019

This bond yields minus 0.1%. Who will buy it?

On 21 August 2019, the Government of Germany auctioned 30-year bonds at a coupon of 0%. When the auction results were announced, the average issue price turned out to be 103.61. Since the bond will be redeemed at par (100) after 30 years, the yield works out to minus 0.11%. In other words, an investor who holds the bond until maturity will (1) not receive any coupon and (2) end up losing money on maturity!

Welcome to a world where bonds yield negative interest rates. It is estimated that about $17 trillion worth of bonds offer negative yields. Some reports suggest that negative yield bonds form about a quarter of the global debt market. The German bond described earlier was probably the first sovereign to make a primary issue at a coupon of 0%.  In Germany, Switzerland, Netherlands, Finland- the yield curve has negative yields through all maturities. Yields upto 15 years are negative in Japan, and upto 20 years are negative in Austria (see pic 1 below)[1].  

 

 Pic 1: Sovereign Yield Heat Map

 

Corporate bonds have also joined the negative yield party. In the first week of September, the German manufacturing company Siemens raised Euro 3.5 billion via an issuance of 2, 5, 10- and 15-year bonds. The demand was overwhelming, and the final yields on issuance were -0.315%, -0.217%, 0.179% and 0.55% respectively.  Never in the history of finance has any corporate raised funds at a negative rate in the primary market[2].

The question that begs to be asked is, why should anyone buy a bond with a negative nominal yield? Doesn’t it make more financial sense to simply hold onto cash, which returns a zero nominal yield? The answer to this question is rooted in the consequences of the easy monetary policy by Central Banks around the world after the 2008 financial crisis.

Two broad types of investors buy negative yield bonds. The first category includes institutional investors like pension funds or insurance companies, who are required to invest predominantly in safe debt instruments. Their investment mandate forces them to buy long term sovereign bonds which matches their long-term liabilities as well as credit quality standards.

The second category includes investors who use negative yield bonds to make tactical gains. They follow one or more of the following strategies to make money.

First, the basic rule of investing- buy low and sell high- applies to negative yield bonds also. If the price of a bond purchased at 103.61 increases to 105.10 after six months, that is an annualized yield of 2.8%. Remember- the yields to maturity may be negative, but investors can exit at a profit earlier if prices increase. And investors in these bonds are betting that interest rates will fall further and bond prices will go up, particularly in Europe.  In its September 12 meeting the ECB is expected to announce more monetary easing through a combination of low interest rates and continuation of its bond buying program. Bond buying by the ECB is a key source of demand for sovereign bonds in Europe, and investors are counting on this to continue.

Second, US dollar investors can earn a positive return from negative yielding bonds because of the additional return from hedging. Hedging costs are mainly driven by the differential in short term interest rates. At this time, key US Fed rates are low but positive, but policy rates in Europe have been negative for some time and are expected to remain so (see Pic 2).

  Pic 2: Policy Interest Rates

 

When a US investor buys a negative yield European bond, he will convert US dollars to Euro at the spot exchange rate. At the same time, he will hedge the Euro exposure by entering into a forward contract, to convert Euros to US dollars at a specified future time at the forward rate.  According to the Covered Interest Parity Condition, a currency offering lower interest rates usually quotes at a foreign exchange rate premium in the forward market against another currency offering higher interest rates. Since interest rates in Europe are lower than in the US, taking a currency hedge enables the USD investor to receive a forward premium[3].  The Financial Times offers this example: if a two-year German Government Bond yields around minus 0.88%, and a currency hedge is taken, it yields around 1.9% for dollar-based investors. This return is better than the yield on a US two-year Treasury bond[4].    

Third, investors can benefit by “riding the yield curve”. This involves purchasing a reasonably long-term bond and selling it before maturity in order to make capital gains. This strategy works because (i) the yield curve is upward sloping in the sense that longer term yields are higher (or less negative) than short term yields (ii)interest rates are declining, not rising (iii) the yield curve is fairly steep for countries like Germany that pay negative yields across maturities. For example, if an investor buys a 10-year German treasury bond yielding -0.58%, and holds it for a year, he now has a 9-year German Bond. If the yield curve is normal, a 9-year bond should have a lower yield (especially if interest rates are declining or constant). Say the market yield for a 9-year bond is -0.68%. This represents a price gain for the investor, which he can capitalize on. 

What are the implications of the negative bond phenomenon? For European governments, it is a good opportunity to borrow cheap and use the money to invest in infrastructure and public works. This is particularly true for Germany, which has the fiscal space to increase government spending. For companies, it is a way to raise low cost debt and expand operations, perhaps in emerging markets where demography and demand are in favour of greater consumption. 

For retail investors in India, the negative bond phenomenon is a mixed blessing. On the one hand, a global decline in interest rates benefits Indian entities seeking to borrow abroad. It makes it easier for RBI to keep domestic rates low, which in turn can stimulate consumption and investment. On the other hand, the underlying reason for low global yields- sluggish global growth and low global inflation- are detrimental to the Indian economy too. With trade war adding to overall economic uncertainty, potential gains  through lower capital costs may not translate into higher demand and growth.



[3] To give a perspective here, domestic interest rates in India are usually higher than interest rates in the US, so a dollar investor has to pay a forward premium to buy a USD/INR currency hedge. In contrast, as European interest rates are lower than in the USA, dollar investors end up receiving a forward premium when they take a USD/EUR currency hedge.

[4] Financial Times, August 15, 2019. “How hedge funds are thriving in a world of negative-yielding debt”. By Laurence Fletcher

 

on Fri, Sep 13th, 2019 6:18:23 am

Dear Ramadas Chadaga, Indian firms are not likely to raise dollar funds at negative rates in the near future because the risk premium on India debt is still fairly high. Note that no emerging market country has negative yielding bonds- there is a still a high default risk attached to that category of issuer. Plus the risk of rupee depreciation will also factor in.

on Wed, Sep 11th, 2019 3:14:44 pm

Simply Superb Article. Generally, Debt Market is very tough to understand. But,The article is written in a simply language. However, it is somewhat hard. Anyhow,It is a good article.

on Wed, Sep 11th, 2019 1:06:49 pm

Is it possible that Companies like TATA and Mahindra may raise these negative yielding bonds in western markets and use the money domestic expansion?

on Tue, Sep 10th, 2019 5:10:11 pm

excellent. the topic which bothered me a lot, clarified well now!

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