The Outlook: August 2019
economic commentary


In focus: negative bond yields

Yields on government bonds have fallen sharply in recent weeks and the global stock of debt with negative yields has risen above US $16 trillion. In Germany, the entire yield curve out to 30 years is negative. In this month’s commentary, we try to answer some frequently asked questions about the growing phenomenon of negative bond yields.

How does a bond yield go negative?
A bond is a debt instrument or IOU that pays a fixed rate of interest. The issuer of the bond (the borrower) pays the holder of the bond (the lender) the interest, or coupon, usually twice a year. When the bond matures, the issuer repays the principal, i.e. the amount borrowed, at face (or par) value. Once issued, bonds can be traded in the secondary market, with the result that the price of the bond can move above or below par, depending on supply and demand.  A bond’s yield to maturity, or redemption yield, turns negative when an investor pays more for a bond than he/she gets back in the form of accumulated coupon payments and principal on maturity.

A negative bond yield does not mean that the holder of the bond pays interest to the issuer. Rather, it’s a situation in which the bond holder gets back less in coupon and principal payments than he/she paid for the bond if it’s held to maturity.

Where are bond yields negative?
Most of the stock of negatively-yielding debt has been issued in Japan, the eurozone and Switzerland i.e. regions where central banks have adopted negative policy interest rates. Japan, accounts for around 43% of the global total, while countries in the eurozone account for around 45%.

Why have government bond yields fallen and the stock of negatively-yielding debt increased in recent weeks?
Yields on government bonds reflect investor expectations for growth, inflation and interest rates. In 2019, developed market bond yields have fallen as the global economy has slowed and the US-China trade war (see our June 2019 commentary) has taken its toll on business confidence, investment spending and manufacturing output. The downward move in yields accelerated in recent weeks as Donald Trump announced a 10% tariff on US $300 billion of Chinese imports not currently subject to duties, prompting equity markets to fall back and driving investors to the ‘safe-haven’ of government bonds. A contraction in the German economy, which has been particularly hard hit by the downturn in global manufacturing, has raised fears of recession and heightened expectations of further monetary easing from the European Central Bank (ECB).

Why would someone buy a bond with a negative yield?
If you buy a bond with a negative yield and hold it to maturity, you are guaranteed to make a loss in nominal terms. Why would anyone buy such a bond? There are several reasons. Firstly, so-called “price-insensitive” buyers are forced to buy bonds no matter how high the price or low/negative the yield. For example, institutional investors such as insurance companies and pension funds might have to buy bonds for regulatory purposes. Furthermore, when central banks conduct quantitative easing (QE) they often commit to buying a certain quantity of bonds regardless of price.

In turn, a speculative bond trader might buy a bond with a negative yield in the expectation that the yield will fall further, thereby generating a capital gain. As expectations of rate cuts and renewed QE from the ECB heighten, many traders will have bought German bunds and other eurozone government bonds with a view to offloading them to the ECB at a higher price/lower yield.

In addition, investors who are worried about the economic and geopolitical outlook might buy bonds in the knowledge that other financial assets (e.g. equities, corporate bonds) would suffer greater losses during any risk-off period. In this sense, investors are seen to be prioritising the return of capital, rather than return on capital.

How negative could yields go?
The extent to which bond yields fall below zero is partly reliant on how far a central bank is prepared to cut its policy rate into negative territory. In turn, this depends on the level at which negative interest rates start to do more harm than good by hurting the banking sector. If rates move too far below zero, commercial banks would be forced to pass the negative rate charge on to households (the Swiss bank UBS is already planning this for wealthy customers) and at some stage, depositors will opt to close their accounts and stash their cash under the mattress. 

Some observers suggest that it could be counterproductive for a central bank to cut policy rates much below the -0.75% rate currently prevailing at the Swiss National Bank (SNB). The expectation that the ECB is about to cut its deposit rate, currently -0.4%, and resume QE has been a key factor in driving the 10-year German bund yield to a record low of -0.73% in recent weeks. But a reluctance to push official rates much deeper into negative territory might limit the extent to which bond yields can fall further from here.

Could we see negative bond yields in the UK?
Concerns over a no-deal Brexit, weak economic data and safe-haven flows have pulled down the yield on the 10-year UK government bond (or ‘gilt’) by 80 basis points or so since the start of the year, but at around 0.5%, it remains positive. With the 10-year yield currently below the Bank of England’s policy rate (0.75%), markets appear to be anticipating a combination of interest rate cuts and a resumption of QE in the not-too-distant future. 

Negative bond yields in the eurozone and Japan have played a part in dragging down yields in the UK. However, for bond yields to turn outright negative usually requires a central bank to adopt a sub-zero policy rate. On 19 August, Bank of England Governor Mark Carney said he did not think negative interest rates were an option for the UK economy at the moment. Governor Carney has previously argued against the use of negative interest rates as they can weaken the financial position of the banking sector, which in turn can have adverse repercussions for the real economy. A disruptive no-deal Brexit, however, could potentially result in “safe haven” flows that push UK yields into negative territory. 

What could cause bond yields to rise?
For core government bond yields to rise, investors would have to start feeling more positive and less anxious about the economic outlook. On the geopolitical front, this would require an easing of tensions between the US and China, a dialling back of protectionism, and a non-disruptive resolution to Brexit. Such outcomes could reverse the flow of “safe haven” flows into government bonds that have helped push down yields. 

Longer-term bond yields could also rise if markets start to expect stronger growth and higher inflation. One way this could come about is if governments attempt to boost the economy by cutting taxes and/or increasing spending. Low/negative bond yields make government borrowing more attractive, and recent reports suggest policymakers in Europe and the US are considering fiscal stimulus. However, in the US there are doubts that a divided Congress will approve stimulus measures ahead of the 2020 presidential election. And in Germany, where a budget surplus provides some scope to loosen the purse strings, there are cultural and legal barriers to a big stimulus (see our March 2019 commentary).

Although monetary policy constraints might limit the degree to which eurozone bond yields can fall further into negative territory, the conditions which might foster a sustained back-up in yields are also yet to fall in to place.

This article is for generic information only and is not suggesting a suitable investment strategy for you. You should seek independent financial advice that takes your individual circumstances into account prior to proceeding with any course of action.

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