Buying bonds with negative yields

Here is an image showing the yields during the past 6 months of the 2-Year government note issued by the country Switzerland.

What’s wrong with the picture?

If you haven’t figured it out yet, focus on the horizontal dotted line and check which yield percentage it represents. Did you find something strange with the yields below the line?

If you answered that the yields of the 2-year Switzerland’s government bond have been negative during the past months, then you are correct. In fact in the past week, the yield of the security has been hovering at -0.30%. That’s a negative 0.30%. That means if you bought it, you are assured of incurring a loss.

Why, then, would you buy an investment with a negative return?

Europe’s debt problem contagion

Bonds with negative yields are a rarity, so rare that they only occur in dire situations. In the case of Europe, however, they seem to be in that situation right now.

Due to growing financial woes, and exacerbated by the Greek debt crisis, several European countries such as Greece, Spain, and Italy, among others, have seen their sovereign credit ratings downgraded. A downgrade means that credit ratings agencies doubt the country’s ability to pay maturing obligations. This leads to an increased cost of borrowing.

If, in the past, the country is able to offer an average yield for its bonds, with the downgrade they will have to increase the yield in order to compensate for the investor’s higher level of risk. If the default risk is too high, the country will have to offer a very high yield as well in order to attract investors.

Higher yield for higher default risk

We have seen this in the case of Greece whose 2-year government bond hit a yield rate of 110.43% in November 2011 (see image below). This means if you got the bond in November, you are promised to more than double the capital you invested.

Doubling your money — that sounds good, right?

Yes, but the problem, of course, is that there is no assurance you will really be paid. Take the case of Greek bondholders who, in February 2012, were forced to accept a 50% haircut or 50% loss on their investment, lest they want Greece to ultimately fall into bankruptcy and into further recession.

How exactly does it happen that bonds offer negative yields?

Investor vote of confidence

In January this year, Germany auctioned $4.9 billion worth of 6-month treasury bills at an average yield of -0.0122%. Early this week, France sold 3-month treasury bills at an average yield of -0.005% while its 6-month treasury bills fell to -0.006%.

Countries whose bonds have negative yields are supposedly the “safe havens.” This is now the case with some sovereign bonds issued by Switzerland, Germany, Netherlands, and France — countries with seemingly low risk of default. Despite the lure of higher yields, investors shy away from the bonds of problematic nations such as Greece, Spain, and Italy, for example, to the extent that the demand for low-risk bonds has been so huge that it pushes the prices of Swiss, German, Dutch, and French bonds higher and higher, ultimately leading to lower and, at times, negative yields.

Buying bonds with negative yields is actually a vote of confidence in the countries offering them. Investors are willing to purchase bonds from these countries and be assured of a small loss rather than risk their money in another country with a possibility of a bigger loss (as seen in the Greek bonds haircut) or even default.

Still, why invest if you are assured of a loss? Why not hold cash or hide your money elsewhere?

Holding cash versus investing in bonds

Of course, it would be easy (and wise) for a small investor with several hundreds or thousands of dollars to put his money in cash. But for a country or an institution dealing with millions or billions of dollars, holding all these in cash form cannot be an option. Also hiding them under the bed or inside a drawer would be absurd. In fact, they will lose money to inflation if they did something like that.

Alternatively, these tons of money can be deposited in banks. True, but with the current market uncertainty, who is to say if their bank will never fail and not declare bankruptcy?

Hence, the best option for most institutional investors is to swallow the bitter pill by accepting a small loss with bonds offering negative yields rather than investing in a country that is at high risk of default or depositing in a bank with no assurance of stability.