The idea of negative interest rates seems strange and isn't explained by classic financial and economic theories, which are all built on the assumption of positive expected return. Traditionally, investors are risk averse and require a positive incremental return for every level of risk taken.

But now that we are seeing negative central bank deposit interest rates and government and corporate bonds with negative yields, there are investors buying into these securities. Why? (To get started, read about: Forces Behind Interest Rates).

Negative Deposit Rates Of Europe's Central Banks

Central banks apply negative interest rates to the deposit as a monetary policy tool to discourage banks from depositing their excess cash with the central banks.

For example, the European Central Bank (ECB) set depositary rates at -0.4% this past March, meaning that it was penalizing banks that hold excess cash with the central bank. It’s an extreme execution of monetary policy, which includes changing interest rates, much like when central banks decrease the rates to stimulate economic activity.

EU countries are currently battling negative inflation i.e. deflation, and the ECB chose to decrease deposit interest rates below zero in order to push banks' excess cash into the economy. (For more, see: Why Is Deflation Bad For The Economy?). The expectation is that banks will be discouraged from negative investing and instead will use the funds to maintain the reference rate at zero and the repo rate at -0.1%. Central Banks of Switzerland and Denmark also apply negative yields as a monetary policy instrument.

Negative Yielding Bonds

Just this past week, Germany began auctioning 10-year bonds at negative yield for the first time. Negative bond yields imply that investors are willing to pay the German government to hold its debt. Including Brexit, there are now over $8 trillion in negative-yielding bonds in the world.

The rationale behind investing in bonds that offer a guaranteed loss:

  • Widening negative yield expectation - Under the current deflationary economic environment, investors who purchase negative yielding bonds may expect the yields to decrease even further, enabling them to profit from the investment.
  • Possibility of a positive real return - In economies where deflation is expected, investors may end up with positive real yield by investing in negative yield bonds.
  • Reallocating cash from more negative to less negative - Since some central banks apply negative yields that are higher than negative government bond yields, investors prefer to withdraw cash from central banks and invest in government bonds which will cost less.
  • Policy allocation – Some institutional investors are required to maintain bonds in their portfolio - particularly investors who specialize in fixed income security investments like bond mutual funds - and they may keep investing in negative yielding bonds in order to be in line with that policy allocation.
  • Currency appreciation expectations – Foreign investors who expect an appreciation of currency against a domestic currency-denominated bond with a negative yield would agree to invest for the positive expected return in the domestic currency. For example, if Country A's bonds has a higher yield than Country B's negative yield bonds, but investors expect Country B's currency to appreciate in value relative to Country A's currency, investing in Country B's bonds may result in higher returns. (For more, see: Why Interest Rates Matter For Forex Traders).
  • Paying for safety - Foreign investors from emerging countries struggling with economic downturns, accompanied by defaults and currency devaluation, would agree to safe-haven buying bonds with negative yields in Europe's economic giants like Germany, Switzerland etc. (To learn more, see: The Advantages Of Bonds).

The Bottom Line

The Eurozone's fight with deflation results in inexplicable negative bond and central bank deposit rates. It’s difficult to see why investors would be willing to invest in instruments that offer a guaranteed losses, but possible reasons are: negative yield widening expectations, increasing deflation expectations, currency rate change and seeking safe investments.

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