How do negative interest rates work?

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There is a lot of confusion surrounding negative interest rates. Matt breaks it down and explains what going negative really means.

Today I am taking a brief detour from writing about the different international bond markets. Instead, my focus is on something that came up in my last post on European bonds—the sometimes puzzling trend of negative interest rates. The idea is that below-zero rates are intended to drive down borrowing costs for companies and households, to help jumpstart an economy. But when I talk with clients and colleagues, I find that there is a lot of confusion about what a negative interest rate really means. How does it work? If I buy a German government bond, do I have to send them a coupon payment? Are they going to bill me? Let me try to demystify what a negative yield is and how it works.

Breaking even

We can start by looking at a simple bond with a positive interest rate. Say you bought a zero coupon bond—that is bond slang for a security that doesn’t make any coupon payments. You buy it at $99 today, and a year later it matures at $100. Your yield is just around 1%. Now, if you had instead bought the bond at $100, and a year later it matured at $100, then you would have realized a yield of 0%. Not the best way to earn income, but at least you didn’t lose any money.

Pay more than what you get back

Now let’s look at an example with negative yields. If you buy the same bond at $101, and it matures a year later at $100, then your yield is -1%. You paid more for the bond than you received back when the bond matured, and you didn’t receive any coupon payments along the way. And this same mechanic can work for a bond that pays coupons. Say there is another bond that pays a $1 coupon in one year, along with the $100 you get back in maturity proceeds, in total you get $101. If you pay $102 for that bond today, then in a year you have again earned a yield of around -1%. You paid $102 in return for total cash flows of ($100+$1) = $101.

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This is how negative yielding bonds work. The coupons on negative yielding bonds are usually either zero or very low, and the negative yield results from the bond price being higher than the interest and principal you will be getting back from the security. When a bond’s yield becomes more negative, it’s because the bond’s price rises while the cash flows it pays stay the same.

Not for income seekers

This naturally leads to the question, who would buy a negative yielding security? Obviously not investors looking for income. However, there are institutions like some insurance companies and banks who hold government bonds for specific reasons, such as to meet regulatory requirements. These investors need to hold bonds for safety, no matter what the yield is.

And, there are some investors who invest in the bond market but don’t focus on the yield of the bond. For example, a fund manager who invests in stocks and short-term bonds. They buy short-term bonds as a way to reduce risk (because they are selling stocks), and also as a source of diversification. For them the negative yield isn’t a big issue because the real value of the bond investment is not in generating yield, but in reducing risk by allowing them to get out of equities.

Ultimately, the international market offers a wide opportunity set, but negative yielding bonds are a testament to how hard it is to source income today.

Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog.

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