What is the Negative Yield Bond?

A Negative yield bond is when the issuer of the bond (borrowers) is paid by the investor (holder of the bond) to borrow money in a negative interest rate environment. Investors end up losing money when they hold such bonds until maturity. For example, consider an investor who, under normal circumstances, would buy a zero-coupon bondZero-coupon BondIn contrast to a typical coupon-bearing bond, a zero-coupon bond (also known as a Pure Discount Bond or Accrual Bond) is a bond that is issued at a discount to its par value and does not pay periodic interest. In other words, the annual implied interest payment is included into the face value of the bond, which is paid at maturity. As a result, this bond has only one return: the payment of the nominal value at maturity.read more below par rate, say, $98, and the security value moves back to par value at maturity of $100. With a negative yield, bond investors buy at a premium price, i.e., above par at $103, and during the term, the price falls back down to a par value of $ 100. A negative yield erodes the value of the security in nominal terms.

Types of Negative Yield Bond

The following are types of negative yield bonds.

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#1 – Fixed-Rate Bond

If the bond is sold at a negative yield at maturity,yYield At Maturity,yThe yield to maturity refers to the expected returns an investor anticipates after keeping the bond intact till the maturity date. In other words, a bond’s returns are scheduled after making all the payments on time throughout the life of a bond. Unlike current yield, which measures the present value of the bond, the yield to maturity measures the value of the bond at the end of the term of a bond.read more buyer does not receive back the total amount invested. The negative yield impacts the maturity valueMaturity ValueMaturity value is the amount to be received on the due date or on the maturity of instrument/security that the investor holds over time. It is calculated by multiplying the principal amount to the compounding interest, further calculated by one plus rate of interest to the period’s power.read more but not the coupon payments, as it is impossible to collect negative coupons from the investor.

#2 – Floating Rate Bond

The reference rate paid on floating notes can be linked to an index such as OIS, LIBORLIBORLIBOR Rate (London Interbank Offer) is an estimated rate calculated by averaging out the current interest rate charged by prominent central banks in London as a benchmark rate for financial markets domestically and internationally, where it varies on a day-to-day basis inclined to specific market conditions.read more, or EURIBOR. E.g., if three months EURIBOREURIBOREuribor stands for Euro Interbank Offer Rate, which is the interest rate at which European Union banks lend funds to one another. It is a benchmark and reference interest rate that changes daily and covers tenures ranging from a week to a year. read more is currently trading at -.020,% means spread below 20 basis points will require payments which are not possible, so below three options exist incorporate negative yield:

  • Add a large spread at initiation, n, which requires a large upfront payment. This is not so popular as FRN investors prefer to buy at the par rate.The negative coupon is netted against early redemption or maturity payment.The third option is the floor option, where the investor must pay upfront costs similar to the option to protect from negative yield, which will be too expensive.

Reasons Behind the Existence of Negative Interest Rate

The following are the reasons behind the existence of the negative interest rateNegative Interest RateWhen the interest rate falls below 0 percent, we have a negative interest scenario. This implies that banks will charge you interest for keeping your money with them. It is more common during periods of extreme deflation.read more.

#1 – Action by Central Bank

#2 – Regulatory Requirement

May force institutional investorInstitutional InvestorInstitutional investors are entities that pool money from a variety of investors and individuals to create a large sum that is then handed to investment managers who invest it in a variety of assets, shares, and securities. Banks, NBFCs, mutual funds, pension funds, and hedge funds are all examples.read more such as central banks (to meet foreign exchange reserves), pension fundsPension FundsA pension fund refers to any plan or scheme set up by an employer which generates regular income for employees after their retirement. This pooled contribution from the pension plan is invested conservatively in government securities, blue-chip stocks, and investment-grade bonds to ensure that it generates sufficient returns.read more (to match liabilities and meet reserve requirements), insurance companies (to meet short-term claims of the policyholder), banks (to meet continuous liquidity requirements and to borrow fund in money marketMoney MarketThe money market is a financial market wherein short-term assets and open-ended funds are traded between institutions and traders.read more they need to pledge collateral to keep a portion of the fund in a liquid form by buying negative yield bonds). They are constrained by the mandate and rules set aside by different regulators.

#3 – Trade-off Between Liquidity and Return

Money market funds to invest in the euro government debt market typically hold a bond with 13 years of maturity—bonds with lesser than this maturity yield negative rates. Buying negative yield bonds is similar to paying the issuer to safeguard your money. There is a trade-off between liquidity and return. The investor does require a return, but on the other hand, they need to keep a certain portion to meet the liquid requirement of clients to facilitate rapid access to cash or cash-like assets.

#4 – To Deal with Economic Slowdown

Buying a negative yield bond is a signal to remedy deflation.

Negative yield arises due to challenges faced by central banks about an economic slowdown. In 2016 slow growth in the global equity marketEquity MarketAn equity market is a platform that enables the companies to issue their securities to the investors; it also facilitates the further exchange of these stocks between the buyers and sellers. It comprises various stock exchanges like New York Stock Exchange (NYSE).read more encouraged investors to shift their allocation from risky assets towards low-risk or risk-free assets such as government bondsGovernment BondsA government bond is an investment vehicle that allows investors to lend money to the government in return for a steady interest income.read more, which led to increased prices to meet higher demands. Bond prices continue to increase as demands surge until the yield curveYield CurveA yield curve is a plot of bond yields of a particular issuer on the vertical axis (Y-axis) against various tenors/maturities on the horizontal axis (X-axis). The slope of the yield curve provides an estimate of expected interest rate fluctuations in the future and the level of economic activity. read more turns negative. Domestic investors buy their government yield bonds if a prolonged period of deflationDeflationDeflation is defined as an economic condition whereby the prices of goods and services go down constantly with the inflation rate turning negative. The situation generally emerges from the contraction of the money supply in the economy.read more is expected.

#5 – Negative Bonds Regarded as Safe Heavens in Falling Market

Some investors believe small losses in negative yield are better than large losses in the form of capital erosion. For example, the European equity market was 20% below their expectations; corporate bondsCorporate BondsCorporate Bonds are fixed-income securities issued by companies that promise periodic fixed payments. These fixed payments are broken down into two parts: the coupon and the notional or face value.read more were defaulting, and commodities prices were falling, so investors moved to safe heavens assets despite providing negative yield during turmoil.

#6 – Currency Speculation

Some foreign investors buy negative yield bonds if they expect to fetch more profitable returns than other asset class returns. E.g., For some foreign investors who believed that the yen would appreciate in the future and hold negative yield bonds denominated in yen after a certain period, the yen did jump drastically, which led to huge capital gain from currency appreciationCurrency AppreciationCurrency appreciation is a rise in the value of a national currency over the importance of international currencies due to an increase in the demand for domestic currency in a global market, a rise in inflation and interest rates, and flexibility of fiscal policy or government borrowing.read more even after accounting for negative yield.

Best Strategies to Deal with Negative Yield Bonds

The following are the best strategies to deal with negative yield bonds.

#1 – Active Investment Strategy

The passive approach involves constructing a portfolio to replicate the returns of the bond index. In contrast, an active portfolio approach involves selecting securities based on unique characteristics and their associated correlations, which determine how they perform on a consolidated basis to achieve a return that outperforms the index. An active manager can minimize the impact of negative yields by adding value to a bond portfolio to take advantage of a relative basis, tactical opportunity to outperform the broader market.

#2 – Diversification Benefits

An investor can enhance return by diversifying a portfolio across different segments of bonds markets, tenors, sectors, industries, and asset class levelsAsset Class LevelsAssets are classified into various classes based on their type, purpose, or the basis of return or markets. Fixed assets, equity (equity investments, equity-linked savings schemes), real estate, commodities (gold, silver, bronze), cash and cash equivalents, derivatives (equity, bonds, debt), and alternative investments such as hedge funds and bitcoins are examples.read more such as mortgage-backed bonds, emerging markets, structured productsStructured ProductsStructured products in Finance refer to a set of two or more assets or securities with a combination of an interest rate and single or multiple derivatives. These pre-packaged investments may include traditional financial instruments, such as equities, options, investment-grade bonds, indices, commodities, mutual funds, exchange-traded funds, or currency pairs, with non-traditional payoffs.read more, asset-backed securityAsset-backed SecurityAsset-backed Securities (ABS) is an umbrella term used to refer to a kind of security that derives its value from a pool of assets, such as bonds, home loans, car loans, or even credit card payments.read more, collateralized loan obligations that offset the negative yield of government bonds at an aggregated level. The volatility of one can be used to offset the volatility of other bonds. As a result, the return will be higher, and the risks will be much lower.

Conclusion

Negative yield does involve payment for accepting deposits. Central banks of nine developed countries have set interest rates below zero to deal with deflation.

This has been a guide to what is a negative yield bond. Here we discuss reasons and strategies to deal with negative yield bonds along with their types and examples. You can learn more about accounting from the following articles –

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