(PUB) Investing 2016

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Although we haven’t yet faced the problem in the
United States, negative bond yields have made head-
lines for much of 2016. But what exactly does it
mean for bonds to offer negative yields and why would
investors be willing to invest in them?
Follow the Math
Although bond math is messy, it’s easy enough
to understand that if you buy a plain-vanilla bond for
$1,000 and it pays 10% per year (if only…), and
you get your $1,000 back at maturity, you’ve made
some money on the deal.
To understand negative yields, though, it’s important
to remember that there’s a big difference between
the coupon rate of a bond expressed as either a dollar
amount or percentage and its yield to maturity. The
former is a simple expression of the payments a bond
makes periodically, relative to its face value. On its own,
it doesn’t tell you anything about a bond’s overall
return. A bond’s yield to maturity is meant to provide a
snapshot of its expected annualized total return,
though taking into account how much an investor pays
for the bond, how much income it produces, and
how much the investor gets back at the end. Whether
you pay more or less than a bond’s face value up
front will have a very important impact on what your ulti-
mate yield to maturity, and thus your ultimate return,
will be. Consider the simple example of a Treasury
bond with a 1% coupon that matures in 10 years. If the
market rate for that bond is a 1% yield to maturity,
its price should be $1,000 (the standard denomination
for a plain-vanilla Treasury.)
What would happen to the price of the same bond if
market yields were to go to zero? Remember, it’s
the same bond, so it’s still paying the same coupons
and will still return $1,000 at maturity. All other
things equal, the value of those coupon payments to
an investor would go up. In fact, if an investor were
to purchase that bond when market yields are at zero,
the price would actually rise all the way to $1,100.
The investor would have to pay an extra $100 in order
to make the transaction worthwhile to whomever
is selling it, because the seller is giving up claim to the
bond’s future coupon payments.
The math is a little trickier once you get to a negative
yield. In that case, if yields were to fall all the way
to negative 1% in the marketplace, its coupons would
become even more valuable to investors, and our
hypothetical 10-year Treasury with a 1% coupon would
actually command a large premium—$211 in
this example.
How Does This Even Happen?
There are several reasons why an investor would buy
a bond with a negative yield. They might do it because
they fear a recession accompanied by deflation. In
such cases, large investors might buy “safe” assets that
charge a premium for that safety.
In today’s environment, though, central bank activity
is the primary driver of negative yields. Against the
backdrop of sluggish economic growth and low infla-
tion, one of the first levers central banks turn to
is to charge for commercial banks to deposit money
with them overnight. That has the effect of pushing
down short-term interest rates, and the impact
typically ripples out to longer maturities depending
on the market’s reaction.
Central banks also contribute to negative yields through
quantitative easing as they buy large enough quan-
tities of long-term bonds to dramatically reduce the
supply and market yields of these bonds.
Negative yields are unlikely in the U.S. The Federal
Reserve chose to leave short-term rates unchanged
in September but left the door wide open for a boost
later this year. Most investors should be reason-
ably content to see them go up as long as improving
economic conditions are the cause. K
Contact Eric Jacobson at
The Strange Mechanics of Negative
Bond Yields
Income Strategist | Eric Jacobson