Imagine someone offering you a deal: Pay him $100 now, and he’ll pay you back $90 in two years. You lose $10 in that arrangement — not a great investment, right? And yet, scenarios like that have been playing out all over global bond markets in recent years. It’s what happens when you have bond yields fall into negative territory.
Here’s what you need to know about negative bond yields, why they occur, and how it all affects you.
What are negative bond yields?
Negative bond yields occur when investors receive less money back on a bond, at maturity, than they originally paid for the bond. In other words, instead of earning a return on the bond, you end up paying money. If that sounds backwards to you, that’s because it is.
In fact, negative bond yields haven’t yet happened in the U.S., and they’re a relatively recent occurrence in other developed economies. But talk of negative bond yields has been in the news as analysts continue to talk about the economic recovery, in the wake of the pandemic.
The concept of negative bond yields makes more sense when you think about what bonds are and how they work in a normal, positive rate environment. In a nutshell, governments and corporations issue bonds as a way to raise money. When you invest in a bond, you are paid interest (known as a coupon rate) until it matures. At maturity, you get the principal back.
Bonds are a fixed-income investment. In essence, you can view them as a way to safeguard your money while earning interest. You can also buy and sell bonds on the secondary market.
A bond’s yield is determined by the coupon rate and the market price of the bond. Coupon rates are fixed, but market prices, as you might guess, change. Those price fluctuations affect bond yield according to supply and demand. The chart below is an example that helps illustrate how this works:
As you can see, the higher the price, the lower the yield. And the lower the price, the higher the yield.
So how do yields get below zero? Yields fall into the negative when prices skyrocket, which is exactly what has happened in countries like Japan, Germany, Denmark, and the U.K. This is a simplified example of a complex concept, but you get the idea. Right now, roughly a quarter of the global bond market is trading at negative yields.
Why buy negative yield bonds?
You might be wondering why anyone would purposely hold on to an asset that pays a negative rate of return. It’s a practice that has prompted heated debate, and some investors have refused to hold bonds with negative yields. But big institutional investors — think central banks, pension funds, insurance companies — are willing to accept a negative return for several reasons.
For one thing, bonds are still considered among the safest assets out there. Stable governments issuing high-quality bonds reliably make good on repayment. For example, investing in U.S. Treasury securities is generally considered risk-free. So large investors may feel it’s worth paying a little to protect a lot, especially in a turbulent economic climate.
In addition, bonds are easy to buy and sell, which makes them easy to turn into cash. That liquidity is attractive when it comes to asset allocation. Plus, investors can pledge bonds as collateral on new loans.
Another reason that investors may be willing to accept negative returns is their outlook on the future market. If investors believe bond prices will keep rising, for example, they may predict that their gains from selling higher in the future will make up for negative yields now.
Some large investors may have no choice when it comes to negative yield bonds. For example, institutional investors in the U.S., like banks, are required to hold Treasury bonds by law — so if the U.S. follows other countries into negative yield territory, those investors would still be required to comply.
What does all this mean for you?
If you’re not a large insurance conglomerate, bond trader, or a hedge fund manager, what does all this mean for you? As with all global market scenarios, the effects on the average investor can be difficult to figure out. Here are a couple of takeaways.
In the short term, negative yields might actually help get the economy going in the same way that negative interest rates are intended to do. The idea is to incentivize lending and spending to inject money into struggling economies. A healthy and vibrant economy is good for individual investors.
But in the long run, negative yields could certainly have an unfavorable impact. For example, pension funds that consistently take losses year over year, may end up having to pay workers a lower income, forcing them to work longer hours to maintain their living situations. And that, of course, makes people less inclined to spend, which can hamper economic growth.
In the end, experts agree that the odds of negative bond yields coming to the U.S., while increasing, are still pretty low. In fact, the volume of negative yielding bonds has started to fall worldwide, even in today’s volatile global economy. But if yields do slip below zero, it could be wise to consider cash options, like Ally Bank Certificates of Deposit (CDs), as a way of safeguarding your money while earning interest as well.
It’s uncertain if we will ever see negative bond yields here in the U.S. But because the bond market is global, it’s become a relevant topic of discussion. What is certain is that investing in bonds can be an effective strategy to offset market volatility, since they’re safer than stocks and a fixed-rate of return.