Negative bond yields are no longer a rarity across the Euro area, accounting for over half the government debt at issue in some countries (Germany, the Netherlands and Finland) and well over a third in others (Austria, France and Belgium). Moreover, what was generally confined to shorter term debt is now extending along the yield curve, and many now expect German 10-year yields (currently 0.15%) to follow Switzerland into negative territory.
Low bond yields are one thing but negative yields are a rare if not unique phenomenon. The former may be generated by a flight to quality but if widespread imply that investors expect short term interest rates to stay low for a long time. That in turn signals an expectation of limp growth and little or no inflation for a prolonged period. Nonetheless, very low yields still mean a positive return, albeit a limited one: if I buy the German 10-year benchmark, which pays a coupon of 0.5% per annum, I will receive €5 per €100 invested in interest , offset by the capital loss on the bond ( it is trading at €103.35). This will reduce my total return over 10 years to just €1.65.
That level of nominal yield is obviously very problematical for savers or for the pension funds that are investing the savings of companies or households. That meagre return is also nominal, of course, and would mean a substantial loss in real terms even with very low inflation over the period.
Nonetheless, any holder to maturity will not face a nominal loss, in contrast to that awaiting an investor with the same time horizon buying a bond at a negative yield . Take the 2% Jan 2022 Bund, which is priced at €113.80. Over the 6.7 years to maturity the interest will amount to €13.40 but this will be offset by the capital loss of €13.80, ensuring a negative nominal return.
Why would anyone buy a bond which gives a loss if held to maturity? Some argue that investors are now simply buying on the expectation that someone else will buy it at a higher price, a classic bubble, but there are other explanations. In the Swiss case investors may believe that the currency will appreciate significantly, so ensuring a positive return for a non-Swiss buyer. One doubts if many expect the euro to outperform most of the other major currencies, however, so other factors are at work. One is QE, in that the ECB is a buyer in the market at any yield above -0.2%. The ECB will not buy all the bonds at issue, however,( the limit is 33% , at least for now) so investors will still be left holding two-thirds of the market.
A second rationale relates to banks, the main buyers of shorter-dated bonds. For them, any excess liquidity deposited with the ECB costs them 0.2% so any yield above that, even if negative, is viewed as a plus. The implication is that banks would also prefer to park liquidity in bonds, however low the yield, than lend it to firms or households – such lending requires higher capital backing and in general carries a higher perceived risk. One should also remember that banks are also now required to hold a specified amount of assets in liquid form, as part of the Basel 111 regulatory changes, which in effect means a greater demand for government bonds at the same time as the ECB has entered the market as a buyer.
For investors as a whole the low or even negative return on bonds is supposed to act as an incentive to switch to other assets, including equities and corporate debt, although again, regulatory constraints for pension funds and insurance companies may make a significant switch into riskier assets problematical.
In the short term, then, a combination of QE and pessimism on growth and inflation has led to a collapse in the risk free rate of return, with the possibility of 10-year yields and beyond turning negative. That has serious practical implications for savers and those relying on annuities in retirement. At another level, it throws up difficulties for asset valuation models, as the risk free alternative is now a negative number. How all this ends is anyone’s guess but there is a paradox at its heart; if QE stimulates growth and leads to a rise in inflation over the medium term, perhaps due to a much weaker currency, it makes negative bond returns in real terms all the more likely for anyone buying to hold at these levels.