Posted by: Uma Shashikant and Deepa Vasudevan on Tue, Feb 17th, 2015
Negative Yields in Europe: Does it Make Sense?
On 4 February, 2015, the Republic of Finland became the first country to sell its sovereign debt at a negative yield. It raised Euro 1 billion by issuing 5.5 year government bonds at a price of Euro 102.2, effectively, a yield of -0.017%. Pic 1 shows the bond specifications: despite the negative yield, the auction was overbid 1.7 times!
Pic 1 Finland Bond Issue Specifications
Within a week, Sweden successfully auctioned SKr3.5 bn ($420 mn)of 4 year bonds at a yield of negative0.05%. Germany was able to raise two year government debt at negative 0.22%. Yields are falling rapidly at the longer end too: last week, Switzerland raised 10-year government debt at the lowest ever recorded rate of 0.011%. That is nearly zero percent, for a 10 year loan. In contrast, Indian and US government bonds of comparable maturity yield about 8% and 2% respectively. Clearly, investors are willing to accept much lower yields from European sovereign debt.
Investors who invest in negative yield bonds and hold it to maturity end up with a lower total return. Even if they earned a positive coupon, since the bond they purchased at a premium would redeem at par, they will end up with a negative total return. Effectively, they are lending to the government and paying it! As an investment choice, it is worse than just holding cash, where the return is 0%. So who would buy such a bond?
Demand for negative yield bonds comes from several sources. First, institutional investors such as pension funds and insurance companies are required to hold a certain percentage of their funds in safe government bonds. For a pension fund based in, say, Sweden, there may be no choice but to invest the minimum mandated amount in Swedish gilts, even if the yields are negative.
Second, those who are betting on a currency appreciation can make up for the loss in yield with the gain in currency. For example, if investors expect the Swiss franc to appreciate against the Euro by 10% over the year, then a Swiss government bond with a small negative yield may still be a profitable investment.
Finally, since yields are negative only if the investment is held to maturity, smart traders can still make profits. The announcement of a Euro 1 trillion asset purchase quantitative easing program has set up expectations that the European Central Bank (ECB) itself will be a prominent buyer of sovereign bonds.
Much of the collapse in Euro yields is in anticipation of the bond buying that will start in March 2015. A further drop in the already negative yields would make the bonds bought at Euro 102 (implied negative yield of -0.017%) to be revalued at a price higher than Euro 102 (implied negative yield >-0.017%). As pic 2 shows, if the bond price was to go up to Euro 103, the total return would be positive. The universal strategy of buying low and selling high need not change just because the underlying YTMs are negative!
Pic 2 Total Return of a Negative Yield Bond
The negative yield story is still being played out. Negative yields are spreading to corporate bonds, and to non-Euro countries such as Denmark and Switzerland. How long it will take for yields to normalize depends on how effective QE will be in reviving inflation and growth.
 For Swedish Government bond auction results, see https://www.riksgalden.se/en/For-investors/Government-securities/Latest-auction-result/Latest/?year=2015
Ramesh B on Thu, Feb 19th, 2015 1:38:17 pm
excellent!all your analysis are superb!
just to add,i went thru' your book on mutualfund in 2002(hdfc mf promoted i think)!thanx. best wishes..
ADIL on Tue, Feb 17th, 2015 11:33:45 pm
thanks, much awaited article, very enlightening.