Negative Yield Bond

A Negative yield bond is when the issuer of the bond (borrowers) is paid by the investor (holder of the bond) to borrow money in a negative interest rate environment. Investors end up losing money when they hold such bonds until maturity.

This type of bond holders receive less money than they had initially invested. Thus, the investors actually pay for lending their money to the issuer. It exists in economic environments where the rates are negative or very low. They are often used in developed countries to combat deflation.

• A negative yield bond is one in which the issuer (borrower) is compensated by the investor (bondholder) for borrowing money in a negative interest rate environment. When investors carry such bonds to maturity, they lose money.
• Fixed-rate bond and floating rate bond are the types of the negative yield bond.
• Dealing with negative yield bonds requires active investment strategies and diversification benefits. Negative yield bonds need depositors to pay for their deposits, and nine developed countries' central banks have set interest rates below zero to address deflation.

The negative yield bonds are also known as sub-zero yield bonds that gives an yield which is below zero. The investors who invest in them get less amount on maturity than their initial investment. Economy with very low or negative interest rate issue such bonds. In some developed economies, central banks implement unconventional monetary policy to fight deflationary situations using such bonds.

The negative yield on a bond is a challenge for investors because they get less than the initial investment if they continue to hold them till maturity. Investors accept such financial instruments only if they anticipate the yields going further down. Investors considering capital preservation more necessary than returns may invest in such bonds.

It is a very unconventional instrument that only suits some investors. Negative yield does involve payment for accepting deposits. Central banks of nine developed countries have set interest rates below zero to deal with deflation.

The following are types of negative yield bonds.

#1 - Fixed-Rate Bond

If the bond is sold at a negative yield at maturity,y buyer does not receive back the total amount invested. The negative yield on a bond impacts the maturity value but not the coupon payments, as it is impossible to collect negative coupons from the investor.

#2 - Floating Rate Bond

The reference rate paid on floating notes can be linked to an index such as OIS, LIBOR, or EURIBOR. E.g., if three months EURIBOR is currently trading at -.020,% means spread below 20 basis points will require payments which are not possible, so below three options exist incorporate negative yield:

• Add a large spread at initiation, n, which requires a large upfront payment. This is not so popular as FRN investors prefer to buy at the par rate.
• The negative coupon is netted against early redemption or maturity payment.
• The third option is the floor option, where the investor must pay upfront costs similar to the option to protect from negative yield, which will be too expensive.

The following are the reasons behind the existence of the negative interest rate.

#1 - Action by Central Bank

A central bank implements monetary policy to manage interest rates and money supply to target economic growth and inflation rates. They also stimulate economic growth by increasing the money supply and cutting borrowing rates through bond purchases. By nature, the yield is inversely related to bond price, i.e., if yield increases, bond price falls, and vice versa. If the central bank continues to purchase the bond in the market, bond prices are pushed higher until rates become negative. So, it can be said that negative yields are a reflection of extremely high prices.

#2 - Regulatory Requirement

May force institutional investor such as central banks (to meet foreign exchange reserves), pension funds (to match liabilities and meet reserve requirements), insurance companies (to meet short-term claims of the policyholder), banks (to meet continuous liquidity requirements and to borrow fund in money market they need to pledge collateral to keep a portion of the fund in a liquid form by buying negative yield bonds). They are constrained by the mandate and rules set aside by different regulators.

#3 - Trade-off Between Liquidity and Return

Money market funds to invest in the euro government debt market typically hold a bond with 13 years of maturity—bonds with lesser than this maturity yield negative rates. Buying negative yield bonds is similar to paying the issuer to safeguard your money. There is a trade-off between liquidity and return. The investor does require a return, but on the other hand, they need to keep a certain portion to meet the liquid requirement of clients to facilitate rapid access to cash or cash-like assets.

#4 - To Deal with Economic Slowdown

Buying a negative yield bond is a signal to remedy deflation.

Negative yield arises due to challenges faced by central banks about an economic slowdown. In 2016 slow growth in the global equity market encouraged investors to shift their allocation from risky assets towards low-risk or risk-free assets such as government bonds, which led to increased prices to meet higher demands. Bond prices continue to increase as demands surge until the yield curve turns negative. Domestic investors buy their government yield bonds if a prolonged period of deflation is expected.

#5 - Negative Bonds Regarded as Safe Heavens in Falling Market

Some investors believe small losses in negative yield are better than large losses in the form of capital erosion. For example, the European equity market was 20% below their expectations; corporate bonds were defaulting, and commodities prices were falling, so investors moved to safe heavens assets despite providing negative yield during turmoil.

#6 - Currency Speculation

Some foreign investors buy negative yield bonds if they expect to fetch more profitable returns than other asset-class returns. E.g., For some foreign investors who believed that the yen would appreciate in the future and hold negative yield bonds denominated in yen after a certain period, the yen did jump drastically, which led to massive capital gain from currency appreciation even after accounting for negative yield.

Let us go through a negative yield bonds example to understand the concept.

For example, consider an investor who, under normal circumstances, would buy a zero-coupon bond below par rate, say, $98, and the security value moves back to par value at maturity of $100. With a negative yield, bond investors buy at a premium price, i.e., above par at $103, and during the term, the price falls back down to a par value of $ 100. A negative yield erodes the value of the security in nominal terms. Thus, the above negative yield bonds example explains the concept.

The following are the best strategies to deal with negative yield bonds.

#1 - Active Investment Strategy

The passive approach involves constructing a portfolio to replicate the returns of the bond index. In contrast, an active portfolio approach involves selecting securities based on unique characteristics and their associated correlations, which determine how they perform on a consolidated basis to achieve a return that outperforms the index. An active manager can minimize the impact of negative yields by adding value to a bond portfolio to take advantage of a relative basis, tactical opportunity to outperform the broader market.

#2 - Diversification Benefits

An investor can enhance return by diversifying a portfolio across different segments of bonds markets, tenors, sectors, industries, and asset class levels such as mortgage-backed bonds, emerging markets, structured products, asset-backed security, collateralized loan obligations that offset the negative yield of government bonds at an aggregated level. The volatility of one can be used to offset the volatility of other bonds. As a result, the return will be higher, and the risks will be much lower.

This has been a guide to what is a Negative Yield Bond. We explain it with examples, its types, reasons for its existence, and strategies. You can learn more about accounting from the following articles –

• Crack Spread Example (3-2-1)
• Agency Bond
• The formula of Yield to Maturity
• What is an Inverted Yield Curve?