If you want to borrow money from someone you pay interest to the lender in return for having that money now, money today is worth more than money tomorrow.

Enter the realm of negative interest rates…

In this crazy world, if you want to borrow money from someone they pay you to take it off their hands.

Negative interest rates are said to be a form of economic stimulus. Indeed, from the line above, it is clear that negative interest rates encourages borrowing. Particularly as you are being paid to borrow.

But does it encourage lending?

Not really.

To explain, let’s focus on one form of borrowing & lending – government bond issuance and investing. These contracts are issued by governments all around the world, and pretty much anyone can buy them. One government bond has a face value of $10,000 of that government’s currency and, if held to maturity, the buyer will receive $10,000 plus interest – being the net of the premium/discount paid plus the coupon rate.

Under normal circumstances the buyer receives interest from the government because bonds are usually paid for at a discount and they usually have positive coupon rates.

If the bond has a negative yield the buyer still receives $10,000 at maturity but also probably paid a premium for that bond initially. In this case, the premium was so high it cancelled out the benefit of a positive coupon rate and so, at the end, the bond buyer actually lost money.

Sounds good for the government, yes?

Only so long as there is demand for it, otherwise they won’t sell any.

So why are investors (including central banks) buying negative yielding government bonds?

For one, the market environment could be so bad that putting your money elsewhere will simply lose you even more money. Yes, things could be that bad. To add to this, banks are required to buy government bonds, regardless of yield, because their prudential regulators require it. Then there are the traders who are buying negative yield bonds because they expect that yields will fall even further making their bonds that they buy now appear valuable.

There’s another aspect to it as well. Interest rates aren’t normally negative, so when they are, it usually means that the market environment is bad. When the market is bad, banks like to hoard their excess capital. It does this by putting it in a nice big savings account. The problem is when the market is bad and the interest rates are negative, this strategy doesn’t work.

Where can the bank put all its money where it isn’t earning negative interest? Back in to the economy by participating in the markets again. Thus, a bank must weigh up the risk of losing 1% p.a. with certainty with possibly losing a bit less by participating in market business (i.e. by not stashing it away until things get better). But when things are really stagnant, like the are in 2019, even market business is hard to find. So the bank can pay borrowers for borrowing their money.

…when the market is really stagnant a bank will pay investors to borrow their money. This way they still lose money, but they lose less money than they would stashing it away in a negative interest rate savings account.

Who Cares About Yield Anymore?

The demand for bonds is so high now, in 2019, that their prices have gone up so much that their yields have dropped in to negative territory. It is as if we have entered a world where yield no longer matters and the price of bonds is what is being traded now. The expectation that the global slowdown will continue to slow and the chances that one or more governments enter various forms of deflationary spirals has gone up. In these types of scenarios, the price of a negative yielding bond is absolutely massive. Forget about the negative yield, the traded price of these things is huge – they may go up 5 or 10 percent before maturity, and if you can sell them, that is a big profit. This only works, however, if there exists a greater fool.

The strategy outlined above indicates that negative yield bonds does not necessarily deny the laws of economics. These negative yield bonds still have positive coupon rates, thus, a loss really only occurs if you hold the bond until maturity.

Governments Buying Bonds

When you hear that the European Union lowers its benchmark rate to -0.5% and resumed buying negative-yielding bonds at a rate of a few billion a month this means that it is literally paying other governments, banks and corporations to borrow money from it. Governments buying other government bonds is known as quantitative easing.

This works because the Central Bank can just simply print the money it needs (pushing up inflation) and invests that in other government and corporate bonds, essentially parting with that freshly printed money, in return for a promised steady income stream denominated in cash either printed by that other government or earned by that corporation. When the bond it is buying has a negative interest rate, they won’t get back as much as they printed, but they will have achieved two things:

  • Stimulated the economy by injecting fresh cash in to the market, and
  • Lowered interest rates by pushing up the price of bonds

while suffering increased inflation and increasing the odds of creating a liquidity trap.

Buying more and more government bonds (even at negative yields) will push up the price of those bonds (supply and demand) which, in turn, decreases the yields.

There is usually a sweet spot of some premium for bond that results in a 0% yield. These days, late 2019, premiums on bonds are so high that 30% of investment-grade securities bear negative yields. Yet investors keep piling in! They are doing this for fear that bond prices will continue to go up and at some point they will be so expensive that no-one will be able to afford them. When that happens there isn’t many options for “risk-free” assets and all sorts of terrible systemic issues will occur.

Since there are no indicators that things will return to normal, investors are simply racing to the bottom – at which point if you were the first in to buy a bunch of negative bonds you would be the winner.

Lastly, if things do continue to perish, holding a bond (even with a negative yield) is far, far superior to holding literally any other asset which can’t share the income-generating aspect of bonds (unless the issuer files for bankruptcy – making negative government bonds very useful in these times).

Corporations Buying Bonds

When corporations have capital they want to save they traditionally store it in a savings account with a bank. In times of recession and deflation the chance that the bank either defaults on its obligations or enters a spiral like a bank run increases to the point where corporations no longer feel safe stashing their money in a savings account. They could buy gold (but that’s another story). The only other option is to store it in government bonds, even if the only option is a negative yield government bond.

Rolling Down the Yield Curve

Even in negative interest rate environments, traders participating in negative bonds can still make a profit. Consider the trader who buys a negative-yielding 3-year government bond and then sells after holding it for 1 year. This trader does not incur the full capital loss from holding it full term, and since debt prices move in the opposite direction of their yields, the value of the 3-year bond should be higher than, say, a 2-year bond, all else being equal. So long as the interest rates for shorter-term bonds are more negative than their longer-dated counterparts, the price for the long-term bond should generally rise as it moves closer to maturity.

However, “rolling down the yield curve” is only a short-term strategy, and that traders must sell the bond well before maturity, because the security will trade only at par when it expires.

For more information on rolling down see the investopedia article here.

Instruments that Benefit from Negative Interest Rates

Imagine buying a 4-year, investment grade European corporate bond with a yield of -3.0%. Sounds terrible? Not unless you can hedge it against a currency with a high yield.

Suppose you are a USD investor in this case. You would buy a USD/EUR FX Forward contract that receives the USD risk-free rate (+2.6%) and pays the EUR risk-free rate (-0.5%). The difference between the two (+2.6% – -0.5% = +3.1%) is known as the interest-rate differential – and in this case is profitable, but it can just as easily be a loss.

When demand is high for US dollars, non-USD investors will be willing to receive less profit when executing the hedge, therefore, from the laws of supply and demand, it must be cheaper for USD investors to hedge their non-USD investment back to US dollars in this case. The size of how much cheaper/dearer it is for this transaction is known as the cross-currency basis swap spread – and is, at the time of writing, about +0.1%.

Swap spreads are generally considered an gauge of risk aversion and systemic risk in the marketplace.

Swap spreads are essentially an indicator of the desire to hedge risk, the cost of that hedge, and the overall liquidity of the market. The more people who want to swap out of their risk exposures, the more they must be willing to pay to induce others to accept that risk.

Factoring in the yield of the European bond we get -3.0%+2.6%-0.5%+0.1%=+0.2%.

For more information see Jens Vanbrabant article on Euro-denominated credit: How currency hedging may benefit USD investors, 2019.

Here is a good article explaining the same thing by Garth Friesen on Forbes.

References

[1] J. Vanbrabant, Euro-denominated credit: how currency hedging may benefit USD investors, 2019.

[2] S. Klingler & S. Sundaresan, An Explanation of Negative Swap Spreads: Demand for Duration from Underfunded Pension Plans, BIS Working Papers No. 705, Monetary and Economic Department, 2018.

[3] J. Kiselak, P. Hermann & M. Stehlik, Negative interest rates: why and how?, arXiv:1601.02246v1, 2016.

[4] Concoda, Who on Earth is buying negative yielding bonds? Medium.com, 2019