Two weeks ago, the world’s first 30-Year zero coupon bond at negative yield flops in Germany with a total value of 824 million euros, causing the whole of Germany’s yield curve to below zero. Effectively, the government of Germany is now being paid to borrow out as it only needs to repay 795 million euros when it expires in 30 years, which means that investors of the 30-year German Bund would actually get back less money than what had been invested if they held through to the maturity. Sounds weird?
Today, negative interest rate bonds are increasingly common and approximately $17 trillion of bonds are now paying negative interest rate amid global economic concerns and speculation of central banks easing across the globe. That represents more than 30% of a total global bond market value of $55 trillion. The trend is actually creeping into Emerging European market, such as Poland, Hungary and the Czech Republic, with their outstanding euro bonds are all trading at negative yields. Now the question is, who in the world is buying all these negative yielding bonds?
Owning negative-yielding bond could make sense if an investor expects future capital gain (e.g., negative interest rate to dip further) or is financing the positions at even more negative rates, which make it possible to earn positive carry. Indeed, with European Central Bank largely expected to restart their asset purchasing program this or next year, negative-yielding European bonds buyers are speculating the bond price will go up further as a result.
Besides, Negative yields don’t necessary mean negative return for some investors too. For example, U.S. investors are buying European or Japanese debt and hedged back into USD as it offers a yield pick-up opportunity. According to interest rate parity, a currency with a lower interest trades at a higher exchange rate in the future. Therefore, U.S. investors of the negative-yielding bond (e.g., two-year German Bund yielding -0.9%) will enter into a forward or swap as the one-year implied forward exchange rate for the EUR vs. USD currently is about 3 percent higher than the spot exchange rate. With 3% return from forward currency hedging together with the -0.9% negative yield from the German Bund, U.S. investors effectively earns a 2.1% hedged yield from this kind of carry trade strategy. This is a typical example of using a derivative contract to take a long-term low yielding asset into a high yield. For instance, a lot of US bond ETFs or currency hedged indexed bond funds are buying negative-yielding bonds and earn a decent return on a currency hedged basis.
Another way investor can make money from the negative yield is to take advantage of the yield curve’s slope. The yield curve represents the gap between shorter-term yields and longer-term, with a steep curve indicating a large difference. As such, very negative short-term yields (e.g., -0.7%) result in positive carry for a 20-year bond (e.g., -0.25% yield) internal European investors as the bond rolls down and the price of the long-term bond should generally rise as it moves closer to maturity. However, this is only a short-term strategy as yield curve’s slope could change drastically.
All in all, the rise of negative-yielding bonds could eventually turn into a bubble for the bond market, in particular today’s easy monetary policy has pushed a lot of money flow into the passive indexed bond funds and ETFs, which many of them are mandated to buy the bonds according to the weight in the index, but regardless of price or future return. Investing in negative-yielding bonds is like playing the musical chair and no one really know when the music will stop. The sudden collapse in interest rate differentials, flattening of yield curve’s slope or upward shocks to forward exchange rate may create substantial loss in negative yield bonds. Therefore, it is always important for bond funds investors to monitor what their funds really invested in and not to have too much exposure on negatively yielding bonds.