Negative-Interest Bonds 101

Bonds, Investing & Retiring

Let’s say we offer to hold 10,000 dollars of your money and pay you back $9,900 after five years. Why would you agree to a deal like that?

That is the very sort of thing that is happening in Europe, with bonds that are literally generating negative interest rates. Germany, France, Sweden, and Denmark all have negative interest rates on their shorter-term bonds. Economic theory suggests that negative-interest bonds should not be possible for any sustained period of time. That theory is being put to the test.

In a manner of speaking, bonds with negative interest rates are playing on expectations that things may be bad now, but they are likely to get worse before they get better. Investors are expecting continued worldwide deflationary forces in the short term, and expecting an even more negative interest rate. The best analogy for that scenario is that investors are assessing whether they would prefer a short-term financial punch in the face or a knife in the back later. If those are our choices, we will take the financial punch in the face, please.

How did we get in this state? The main reason is supply and demand, and manipulation of the typical supply-and-demand model by governments and central banks.

Consider that if there is limited demand for bonds, the interest rate has to go up to entice buyers to make the investment. Conversely, when the demand is high, interest rates will fall. With a pessimistic outlook for future growth, bonds are in higher demand as a safe investment compared to riskier stocks. Governments are reluctant to go further into debt and issue new bonds, thus there are fewer low-risk government bonds to be purchased.

To apply the final bit of pressure, governmental bond-buying stimulus programs distort the supply and demand curve even further. While the U.S. has completed its program, the Eurozone embarked on a €1 trillion stimulus program.

In Europe, that is a particularly tricky proposition, because while Europe has a common currency, there are no collective European bond equivalents. Each country has its own bonds, backed by the full faith and credit of that country. How the European Central Bank (ECB) handles its bond purchases will have quite an impact on individual countries’ bond markets. Concerns of a potential Eurozone breakup makes bonds from Germany or similarly strong countries preferred to those of weaker countries like Portugal or Greece, driving demand up and rates lower still.

Still, why buy at a negative rate? There are several reasons/excuses.

  • Currency – Currency appreciation over the bond’s maturity period can overcome the negative interest rate. For example, had you invested in Swiss bonds at the end of 2014, you would have been paying a small negative interest rate but the Swiss Franc shot up 30% against the Euro after the Swiss central bank removed the cap on its currency.
  • Passively-Managed Funds – “Set it and forget it” funds may have automatic purchases based on specific risk formulas. These formulas probably do not account for a negative interest rate in looking for low-risk bond components — because until recently, why would they need to? These funds may be purchasing German short-term bonds or similar vehicles purely based on a pre-set risk profile.
  • Safety – The low-risk component of the portfolios of the very wealthy have to go somewhere. If you are in Europe looking at your options, you see banks that are charging no (and in some cases negative) interest with bank guarantees that may be in the range of €100,000. Meanwhile, fully backed government bonds carry more security against default or bank runs and a similarly poor rate. Pulling your safe money completely out of investments would entail a different set of risks. One punch in the face it is.

Banks also have incentive to buy these bonds if they are being charged by central banks to handle their reserve funds and there are an insufficient number of qualified borrowers to loan the money to.

For the average investor, it makes little sense to consider negative-interest bonds because you have other options for the low-risk end of your investment strategy. However, the concept is not as ridiculous as it sounds within certain boundaries. It does make us wonder about the soundness of central bank policies and their assumptions regarding stimulus, especially within the Eurozone.

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