Why would investors with lots of cash invest in bonds with negative yield?

Investing, Bonds / Fixed Income
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February 2016

An excellent question. At first glance, it’s not clear why anyone would buy a bond that actually requires the investor to pay interest to the bond issuer. And yet that’s exactly what you do when you buy a bond with a negative yield. It’s estimated that $7 trillion worth of bonds worldwide now carry a negative yield. On further inspection, it turns out there are sound reasons for one to accept a negative yield under certain circumstances.

Until recently, the concept of an interest rate below zero was mostly confined to the realm of theory. But as economies around the world struggle, central banks have taken extreme measures in an attempt to stimulate economic growth and avoid price deflation. Negative interest rates are one of their tools. The theory is that negative interest rates encourage more business borrowing and spending on plant and equipment, as well as encouraging investors to seek out riskier investments with higher expected returns. In turn, that pushes up asset prices and perhaps stimulates consumption. The jury is decidedly out on whether this actually works.

There are at least a couple situations where it can make sense for an investor to accept a negative interest rate. One case is that of institutional investors who are required by their investment policy to maintain holdings in the shortest term, safest instruments available, for example, Treasury bills. If the interest rate on such investments happens to be less than zero, these investors really have no choice but to accept the negative rate. While in theory one could obtain paper currency and store it in a vault, this is impossible for the world’s multi-trillion dollar money markets as a whole, particularly given the need for electronic safekeeping and instantaneous liquidity.

A second situation where it would make sense to accept a negative yield is in an environment of deflation, that is, falling prices. For example, if prices are dropping at a rate of 3% per year, an interest rate of -1% would actually represent a positive inflation-adjusted rate. To see how this would work, suppose you have $10,000 dollars today and you invest it at -1%. One year from now you will have $9,900. However, you would only need $9,700 a year from now to buy what $10,000 buys today (since prices will have dropped 3%). Thus, in our example, $9,900 a year hence represents an increase in purchasing power versus $10,000 today.

Alas, for years bond investors have been accepting rates that in many cases don’t even match inflation, and this represents one of the great investment challenges of our time.