Why are low and negative yields possible and are they sustainable?
Late 2014 saw the clear emergence of negative-yielding bonds, capsizing the basic assumption of debt; that borrowers pay interest to lenders on the money that they borrow. Lenders who buy these bonds will end up losing money at maturity. The market value of these bonds has been increasing since they first emerged and for a wide variety of reasons. The main contributing factors are economy stimulating monetary policies introduced by central banks and investors risk preferences shifting to an even more risk averse inclination.
From a rudimentary stance, it is apparent that an active monetary policy adopted by many industrialised nations after the 2008 financial crisis has a prominent part to play in the prevailing trend of low and negative bond yields at the beginning of 2015. Central banks have been buying large amounts of government bonds to drive yields lower in an effort to stimulate economic growth by incentivising investors to invest in riskier assets. Pimco (2015) suggests “Central banks in major developed economies have amassed close to $10 trillion in government bonds since 2014, and still remain a source of demand of close to $3 trillion more a year”, the article continues to state that the net issuance of government bonds which is less than this amount has been on the decline at the time of writing. It is very likely that this relationship of bond supply and demand has caused extremely low and even negative yields.
The adoption of a more active monetary policy was not the only ideological shift in the financial world post 2008; once investors experienced first-hand how “safe” banks really were in practice, this instilled fear and increased how risk-averse these investors were. Paying a premium to keep your money safe would seem reasonable. When explaining why investors may decide it be worth accepting a negative yield of 0.16%, Lloyd (Cited in The Economist, 2015) says “In effect you’re paying a 16-basis-point custody fee for keeping your money safe”. This rationale not only explains an increase in demand for bonds even at low yields, but also why investors accepted these low bond yields in 2015.
“Safe” investors are not the only ones who opt to buy these low yield bonds, however. Although bond yields were low and sometimes even negative, speculators could make higher ‘real’ returns than the bond yields due to deflation and currency gains. If investors expect prices to fall steadily, inflation would be negative. To safely secure having more purchasing power in the future, buying negative yield bonds is a viable option if the expected deflation rate is higher in magnitude than that of the bond yield.
Purchasing power parity is a popular macroeconomic metric that compares economic productivity and standards of living and conceptually explains that in the long term, exchange rates adjust according to differences in good pricing between countries. This means that a country with a high inflation rate will have its currency’s purchasing power decrease and a country with a negative inflation rate will see its currency’s purchasing power increase. This means that if investors in a country with a relatively high inflation rate buy bonds in a country with a relatively low or negative inflation rate, in the future they expect to be able to exchange the foreign currency they gain at bond maturity at a higher exchange rate back to their domestic currency due to exchange rate changes, this means the investors will have made great returns on even negative yield bonds.
Holding a bond for its coupon payments until maturity, however, is not the only way an investor can make a profit (or make a loss). Most bonds are traded on the secondary market between lenders, not just between borrowers and lenders and are done so between bond issue and bond maturity. A bond may be moved between many different owners (lenders) from its inception to the date of maturity. This is because bond prices can change when interest rates change, and speculators can try and profit from this. Demonstrating this with a zero-coupon bond for simplicity, if a zero-coupon bond (Bond Z) is currently trading at $900 and its par value is $1,000 (paid at maturity in one year), then the zero-coupon bond yield would be approximately 11.11%. If interest rates were to decrease, giving newly issued bonds a yield of 5%, since the yield for Bond Z is much higher than other bonds available, this will increase the demand for this bond up until it’s price also corresponds to a yield of 5%. The price of this bond would go from $900 (with a yield of 11.11%) to $952.38 (with a yield of 5%). In theory if an investor speculates that interest rates will decrease, they could buy the bond for $900 and sell it for $952.38 to make a profit of $52.38 without having to wait for maturity. Bond prices tend to be less volatile the lower the yield is and therefore there are less traders during times of low bond yield — this could contribute to explain why historically periods of low bond yields have lasted so long (as demonstrated on the chart below).
Although this suggests that the bond markets will experience low bond yields for many years to come, this is ultimately not sustainable. In the long term, bond yields are very close to long term GDP growth. GDP growth has been much higher than 10-year bond yields for a while now and in the long term, they should theoretically increase to around nominal GDP growth numbers. This does, however, heavily depend on the actions central banks take in line with their nation’s monetary policy. The speed at which the bond market returns to these bond yields is very much determined by how successful central banks are at matching their inflation targets.
Additionally, these really low rates on the safest bonds will have residual effects in other markets. Corporate junk bonds, for example, also have negative yields. Ainger (2019) says that, “Investors are bidding up the prices of all kinds of risker assets — from equities to emerging-market bonds — in search of better returns”. This means that as these low yield bonds become less attractive, investors are flocking to riskier assets with higher returns and in turn causing the same low yields in other assets. This could be detrimental as this can cause investors to overprice assets in the stock market, in turn leading to riskier sizeable investments in stocks in companies without economically sound fundamentals. Not only is more capital being invested into riskier assets, but major European lenders profitability is being cut during times of low bond yields.
To conclude, low (even negative) bond yields has been caused by the active monetary policies of central banks in developed nations in a bid to control the supply of capital in the country. Central banks increase the money supply by buying bonds, this increases the demand for bonds artificially and causes their price to decrease, since these prices are closer to the par value (or even higher), these bond yields will be extremely low or negative. Investors are still investing in bonds as they are the safest financial instruments to hold your money in as well as one of the most liquid, people are willing to pay a premium on keeping their money safe. There are also opportunities to make money through deflation and the theory of purchasing power parity between exchange rates. While this does stimulate economic activity, it also increases the amount of capital in much risky assets, if this isn’t controlled for then along with the fact that lenders are losing profit, the economy will be in danger if this is kept up. I can conclude that these low or even negative exchange rates are unsustainable.
Reference List
Pimco, 2015, Why the Bond Market Is Yielding Negative and What Negative Yields Mean for You, viewed 22 April 2020, <https://europe.pimco.com/en-eu/insights/viewpoints/why-the-bond-market-is-yielding-negative-and-what-negative-yields-mean-for-you#/fancyMyContent>
The Economist, 2015, Accentuate the negative, viewed 22 April 2020, <https://www.economist.com/finance-and-economics/2015/01/22/accentuate-the-negative>
Angier, J 2019, The Logic Behind the Bonds That Eat Your Money, viewed 22 April 2020, <https://www.bloomberg.com/graphics/2019-negative-yield-debt/>
