When investors buy bonds, they are essentially lending money to bond issuers. In return, bond issuers agree to pay investors interest throughout the lifetime of the bond and repay the face value upon maturity. The money that investors earn through interest is called yield. Many times this yield is positive, but there are certain circumstances where the yield can also be negative.
Understanding Negative Bond Yield
If a bond has a negative yield, it means the bondholder loses money on the investment, although this is an uncommon occurrence. Whether a bond has a negative yield largely depends on the type of yield being calculated. Depending on the purposes of the calculation, a bond's yield can be determined using the current yield or yield-to-maturity (YTM) formulas.
- Current Yield
The current yield of a bond is a simple formula used to determine the amount of interest paid annually relative to the current selling price. To calculate, simply divide the annual coupon payment by the bond's selling price.
For example, assume a $1,000 bond has a coupon rate of seven percent, which means that the bond pays $70 annually in interest, and is currently selling for $700. The current yield would be 10% [($70 ÷ $700) * 100].
Using this formula, it is nearly impossible for a bond to have a negative yield. Even if the price is substantially above par, a bond that pays any interest at all will always have a positive current yield. For a bond to have a negative current yield, it has to pay negative interest.
- Yield to Maturity
The YTM calculation is a more comprehensive yield formula because it incorporates the financial impact of the bond's selling price and par value. A bond's par value is the amount the issuing entity must pay the bondholder at maturity. A bond's YTM, therefore, represents the rate of return an investor can expect if the bond is held until it matures.
Since the YTM calculation incorporates the payout upon maturity, the bond has to generate a negative total return to have a negative yield. For the YTM to be negative, a premium bond has to sell for a price so far above par that all its future coupon payments could not sufficiently outweigh the initial investment. For example, the bond in the above example has a YTM of 16.207 percent. If it sold for $1,650 instead, its YTM goes negative and plummets to -4.354%.