Why do investors buy negative yield bonds?

Negative yielding debt is the most striking consequence of aggressive central bank policy. The amount of bonds with negative market interest rates is near $7tn and appears set to grow. Buying a bond with a negative yield, and holding it to maturity is a guaranteed way to lose money. So why would anyone do so?

Because central banks will keep buying

Central banks have sought to stimulate economies through bond purchases. They hope to encourage lending by cutting borrowing costs, with the ultimate aim of boosting economic growth. Negative bond yields are a feature of this policy, not a bug.

The lower the yield on a bond, the higher its price. If a bond pays a coupon of 1 and has a price of 104, and it matures in a year at 100, the yield, or return, is negative. So negative yields are a simply a reflection of extremely high prices, which could be pushed higher by further demand such as central bank purchases.

Because you have to

Institutions and investors which buy bonds and shares globally, are constrained by mandates, sets of rules dictated by the banks, pension funds or insurance companies from whom the money comes.

The layered bureaucracy of the buyside can effectively force some investors to buy negative yielding debt. Money market funds, for example, typically invest in bonds up to a maturity of 13 months. For large amounts of the euro government debt market, bonds of a maturity shorter than this are negative yielding; German government bonds are negatively yielding up to a maturity of eight years.

For some clients, regulatory requirements may force them to buy certain types of assets — banks, for example, are required to hold liquid assets.

It’s better than holding cash

Buying negative yielding debt might be considered similar to paying a government to guard your money in a vault. Government debt, though, is “liquid” — it can be bought and sold swiftly at little cost.

Investors need returns, but they must balance this with a need for liquidity — providing their clients with rapid access to cash or cash-like assets.

Cash is the most liquid of assets. But central banks have imposed negative interest rates on cash deposits, which stands to trickle through to the rate banks charge institutional investors. A highly liquid but slightly negative yielding government bond might look more attractive by comparison.

Because the world is terrifying

Negative yields as a phenomenon reflect the challenges of central bank policy and expectations around economic growth. In a stagnant world, negative yielding bonds are both signal of and hoped for remedy to deflation.

Global equity markets have been rocked by economic fears so far in 2016. Not only might these fears consolidate the view that growth will slow further and push bond prices higher — they may also encourage investors with some flexibility to move their allocations away from risky assets and towards havens, reasoning that a small loss will constitute “over-performance” if other asset classes take double-digit losses.

As fears grow, demand for haven assets grows. With bonds, this can push prices so high that yields turn even more negative. The supply of bonds, in a world where governments seek to curtail the levels of spending seen in the past, could also be constrained. These long-term dynamics could normalise permanently lower, if not negative, yields. They certainly seem different to the dynamics of the economies in which the modern bond market was shaped.

What’s the downside?

The danger, and one of the great ironies in a world of negative yielding bonds, is that prices for instruments designed to be safe and dull have become volatile. Consider the German 10-year Bund yield, not yet negative, which last spring unexpectedly surged back towards 1 per cent.

But ever lower yields mean capital gains — a reward for the continual risk of changing policy. Investors who bought German Bunds at the start of the year have made 4.2 per cent so far in 2016, according to Barclays government bond indices. Not a bad return, if the world is falling apart.