Why would you buy an investment with a negative return?
Did you know that back in 2012, the yield of the 2-year government bond issued by Switzerland has been negative? At one point, the yield of the Swiss government bonds 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 invest your money in an investment assuring you of a loss?
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, they seemed to be in that situation back in 2012.
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 credit ratings 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. 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 indeed be paid. Take the case of Greek bondholders who, in February 2012, were forced to accept a 50% haircut, that is, a 50% loss on their investment, lest they want Greece to ultimately fall into bankruptcy and into further recession.
Why do bonds offer negative yields?
In January 2012, Germany auctioned $4.9 billion worth of 6-month treasury bills at an average yield of -0.0122%.
France then 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 has been 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 bond issues of problematic nations such as Greece, Spain, and Italy, 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, 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.
* Check out our comprehensive Bonds tutorial here: How to Invest in Bonds in the Philippines
