Bonds are fixed-income vehicles that provide investors with a safe and secure form of investment. They are issued by governments and corporations, which do so in order to raise money. When an investor purchases a bond, they essentially become lenders.
Bond issuers borrow money for a certain period of time, promising to repay the investor back in full on the maturity date. In exchange for the principal balance, the bond issuer also agrees to pay the investor a certain amount of interest at regular intervals. This return is known as a yield.
Sometimes, bond yields end up being negative. It is an unusual circumstance but it does happen. This means that the bondholder or lender ends up receiving less money when the bond matures than the amount for which it was purchased. To understand how that can happen you have to know how the yield on a bond is determined.
- Bonds are fixed-income vehicles that provide investors with a steady stream of income until the maturity date.
- Yields are the returns paid to investors from the bond's interest payments.
- A bond's current yield is the amount that will be paid in interest on a bond over a one-year period, expressed as a percentage of its face value.
- Yield to maturity is the amount that will be paid from now until the bond expires, also expressed as a percentage of its face value.
- In rare circumstances, the yield to maturity may be a negative number.
Understanding Bond Yields
The return that a bond provides an investor is measured by its yield, which is a percentage of the bond's face value. The current yield of a bond is the commonly quoted number that is used to report the return on a bond for a one-year period.
Note that this accounts only for the interest amount, which is also known as the coupon payments, that the bond pays to the investor. The current yield is calculated by dividing the bond's coupon rate by its current market price. Keep in mind, though, that this number doesn’t account for any capital gains or losses incurred when the bond is sold.
If the bond is held by the investor for one year, this yield as quoted accurately reflects the total return that the bondholder has received. The bond's current yield can only be negative if the investor received a negative interest payment, or if the bond had a market value below zero. Both of these are unlikely events.
Negative bond yields are mainly relevant to bond traders who buy and sell bonds in the secondary market—not to individual investors who buy bonds at face value and hold them until their maturity date.
Calculating Yield to Maturity (YTM)
Other calculations of yield take additional factors into account and can be used to more accurately evaluate the returns an investor may receive. One of those is a bond's yield to maturity (YTM).
As its name suggests, the YTM indicates the bond’s return. This is expressed as an annual percentage as long as the investor holds the bond until it reaches its maturity date. This formula takes into account all of the coupon payments and the face value or par value, on the bond. This is generally seen as a more accurate evaluation of a bond's value than the current yield.
Calculating a precise YTM may be difficult, which is why it's often a good idea to estimate this figure by using a financial calculator or, better yet, a bond yield table.
A bond may have a negative YTM calculation. It depends on how much more than par value the investor paid for it and how many payments will be made before it reaches its maturity.
Example of Negative Bond Yield
As noted above, calculating a bond's YTM is complex and involves significant trial and error. While it is usually done by using a software program, an approximate YTM can be obtained from a bond yield table. When using the YTM calculation, it is possible to have a negative yield on a bond, depending on how much one initially pays for the bond and its time to maturity.
Let's say an investor pays $800 for a bond that has exactly two years left to maturity. It has a face value of $1,000 and interest payments of $8 per year. In this scenario, the bond table will show that the bond will have a YTM of about 10.86%. If the bondholder had paid $1,200 for the bond, the YTM would be about -9.41%. Keep in mind, though, that a bond will not necessarily present a negative actual yield simply because the investor paid more than face value for it.
The Bottom Line
All of the above is related to the normal functioning of the bond market in the U.S. As of late-2020, more than a quarter of global bond debt had a negative yield. This is because, in an era of extremely low-interest rates, many large institutional investors were willing to pay a little over face value for high-quality bonds. They accepted a negative return on their investment for the safety and liquidity that high-quality government and corporate bonds offer.