Negative Yield Bonds Explained - Why People Still Buy It?
Let's consider this example. You buy a bond which has a face value of 100 dollars for 5 years. Every year, you will get paid some interest based on some interest rates called coupon rate, say 2% per year. So every year you can get 2 dollars based on that interest rate. At the end of the 5-year period, you will get the $100 back. If the bank saving interest rate is less than 2%, buying this bond will be a better investment option than saving money in the bank.
However, sometimes the bond yield might drop to a number below zero such as -2%. This means you have to pay the bond issuer 2$ each year. So, at the maturity date of the 5-year, you will get a loss of 10$ in total. You may think investing in such a bond will be a crazy idea. However, under some circumstances, many people still choose to invest in a bond which has an expected negative yield.
Although the interest rate is an important factor for a bond, there are many other factors which may affect people's decision to invest in a bond. The first reason is that many investment firms have a requirement for asset allocation. This means they have to keep a certain percentage of bond products in their portfolio to reduce the risk even if their yield is negative. Some government bonds are considered as safe-haven investments. Compared with other investment products, those bonds have the lowest risk and must be a part of investment in many fund managers' portfolios.
The second reason is that some special funds, such as pension funds, need those bonds to satisfy the needs for asset and liability matching.This means they need to find suitable fixed-income financial products which can provide cash flows to match against the liability cash outflows such as monthly pension payments to their customers. Most of the issuer of those investment grade bonds such as those triple-A government bonds has a good reputation and they will pay the interest periodically, which can satisfy the needs for the liability matching. If the bank saving rate is worse than the bond rate, the choice to invest in bonds will also be a better idea.
The third reason is that other factors such as currency exchange rate, central bank interest rate and expectation of deflation may also affect the value of the bonds. For example, if the market think the interests will be raised in the near future, the buying price of the bond will decrease. This is because people will think more money will flow from the bonds to bank saving because there is a higher interesting rate for saving. Conversely, the bonds buying price will increase. This result in the fluctuation of bond prices which is able to make some profits from it. For example, we bought a bond at its face price of 100 dollars, the market is considering the central bank will lower the interest rate in the near future, which result the in the bond buying price to be raised to 105 dollars. If we sell this bond, we can get a profit of $5. Considering this bond may have a negative yield of -2%, we still have a finally profit of $3. The exchange rate will another factor which will enable us to make profits from negative yield bonds. For example, if we use 100 currency A to change to 100 currency B at a rate of 1 to 1, and then buy a currency B bond which has a negative yield of -2%. After a year, the exchange rate changed to 1.1 to 1. If we sell the bond and change it back to currency A, we can get $107.8, which means we still get a $7.8 profit. Also, if people have an expectation of deflation ahead, they may try to save money even it has a slightly negative yield. They will think the price of goods and services will be cheaper in the future and saving money can enable them to buy more by then.
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