For quite some time now, several governments have been issuing bonds with negative interest rates. Even some large corporations have been able to do so. Our gut reaction is to dislike negative interest rates—why, indeed, would anybody be fool enough to pay an interest rate in order to lend money, i.e. to take a risk without apparent reward? Buying a bond with a negative interest rate is basically the equivalent of your bank paying you to borrow money from them. It makes hardly any sense when looking at it this way, but there are actually many reasons to buy negative interest bearing securities.
A bit of economic theory
Before jumping into the topic, let's first consider interest rates from a theoretical point of view. Interest rates can be broken down as follows in traditional finance theory:
interest rate = real interest rate + inflation premium + default risk premium + liquidity premium + maturity premium
Let's take a look at a few notes about government bonds with negative interest rates:
- Typically, negative interest rate bonds have a short maturity, and thus a low maturity premium, as it is not needed to reward investors for long-term risks if they purchase short-term securities.
- The liquidity premium is also very low: there is a huge secondary market, which means that it is easy to sell such securities.
- The default risk premium is also rock-bottom low. Governments are the most reliable economic agents when it comes to solvency. They sometimes default, but it is assumed that large western governments will not default on their debt.
- The inflation premium is also very low, as inflation is typically low in countries that issue negative interest rate bonds (see more below).
- Finally, the real interest rate, which consists in an opportunity cost (I lend you money; therefore I cannot consume now, nor can I invest in other things) is also very low: in a very volatile environment, where a lot of political and economic risks are present, government bonds act as a safe haven. Thus it is not shocking to pay to hold them.
In short, negative interest rates are fully compatible with the above-mentioned economic theory. Let's now take a look at who precisely are the investors who buy such securities.
Since the 2007 financial crisis and the fall of Lehman Brothers, authorities have tried to enforce regulations to ensure the stability and resilience of the financial system. Part of these regulations consist in forcing banks and insurance companies to hold liquid assets to back their loans. These assets must be liquid, and carry a very small risk: their goal is to protect the bank against illiquidity or insolvency, not to generate a high return or to increase the bank's risk.
Only a limited number of securities are eligible to be part of these risk-free liquid assets. Paramount are government bonds. Thus, financial institutions purchase them, not as part of an investment strategy, but purely to fulfil legal requirements such as the ratios imposed by Basel III or Solvency II.
Coincidently, this creates a huge distortion in the market, as these institutions generate a huge demand in the market, driving interest rates lower. Indeed, a higher demand for bonds translates into lower interest rates, as issuers can offer less favourable terms and still find buyers for their bonds.
The role of central banks
But the commercial banks and insurance companies are not the only ones who do not really care about returns and buy no matter the yield. The biggest players in that field are central banks. The ECB buys €80bn in securities each month. The Bank of Japan held $3.2tn (Ą366tn) in Japanese government bonds as of 28 February 2017, or close to a third of the Japanese national debt.
The objective of the quantitative easing policy implemented by these central banks is to increase the money supply in the hope of propping up inflation and pumping up economic activity. The fruits of this policy seem to be taking time to materialise: inflation in 2016 was 0.3% in the Euro area and in Japan. Economic growth is also stable at a low level in these two regions. Nevertheless, central banks are trying to increase both the size of their intervention and its scope, regularly adding new securities to the panel of eligible instruments that they can purchase.
In addition to this massive intervention, central banks also hold bonds as part of their foreign exchange reserves, alongside cash, gold and other financial instruments. For example, the ECB holds a large number of debt instruments as part of its reserves ( about €200bn), mainly denominated in US dollars and Japanese Yen ( policy statement). This also increases the demand for bonds, and thus contributes to decreasing the required return.
Betting on currencies
Though central banks and financial institutions subject to heavy regulation might represent the largest part of the demand for negative interest rate bonds, others can also be interested in purchasing such securities. One kind are investment funds with a global macro strategy. These funds try to generate returns by forming accurate expectations about economic trends, which may also be reflected in the movement of financial markets.
For example, some investors might want to bet that the Japanese economy will recover, that Japanese domestic demand will increase, and that the Yen will thus appreciate. To take this bet, it would seem that a fund could simply buy Yen—but it is not that simple. The investment policy of the fund might not allow it to hold a large amount of cash. Therefore, the fund will want to buy liquid and relatively riskless assets denominated in the desired local currency. Government bonds are a very good fit: they are considered among the less risky assets, and benefit from a satisfactory liquidity. Even if the interest rate on the security is slightly negative, the fund could still make a profit out of the currency appreciation. An investor holding Yen during the first half of the past year would have made a 13% return.
In short, negative interest rates are not always sufficient to make an instrument unattractive: looking at the broader picture, with cross currency transactions, these securities can actually be interesting speculative tools.
- Negative interest rates are fully compatible with economic theory and represent effective expectations of the economic agents at play.
- Financial institutions have to hold bonds for regulatory purposes, no matter the return and no matter the interest rate.
- Central banks are flooding the market with cheap money and buying huge numbers of bonds as part of their economic policy.
- Investors may use government bonds as proxies to bet on currencies, even though the interest rates are slightly negative.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.