Negative Yield to Maturity and Its Impact

Negative yield to maturity is a phenomenon where investors pay more to buy a bond than its face value, essentially lending money to the issuer at a cost. This is exactly what happened in the global bond market in 2020.

The main reason for this is the extremely low interest rates set by central banks in response to the COVID-19 pandemic. As a result, many investors are willing to accept negative yields in search of stability and security.

Investors are essentially paying for the privilege of holding the bond, which is a stark contrast to the traditional concept of earning interest on investments.

Negative Yield to Maturity (YTM) occurs when the bond's market price is higher than its face value, which means investors pay more to buy the bond than they'll receive back at maturity. This results in a loss for the investor.

The Yield to Maturity (YTM) takes into account the bond's current market price, face value, and redemption value. Credit quality and prevailing yields on similar bonds in the market also affect the YTM.

In a negative-yielding bond, investors don't actually pay the issuer, but rather pay a premium for the bond that exceeds the income they'll receive during their holding period. This premium is the difference between the purchase price and the par value of the bond.

Here's a simple example of how negative yields typically work:

In this example, the investor pays $5 more than the face value, but only receives $4 in interest, resulting in a negative yield.

Let's break down what we mean by certain terms. Mainstream news sources often confuse "interest rates" with the rates banks charge to lend to each other, such as the Fed Funds Rate in the U.S.

The coupon rate of a bond is the rate it pays in interest, and it applies to the face value of the bond. This means that even if the bond's market price changes, the government keeps paying the same interest rate.

Credit quality and prevailing yields on similar bonds in the market affect the Yield to Maturity (YTM). The YTM is different from the coupon rate because it also depends on the bond's current market price and its redemption value.

The market price of a bond can be affected by the yields of similar companies issuing bonds. If similar companies start issuing bonds at higher yields, a company's existing bonds will become less attractive, pushing down their market price.

A negative yield bond is when the issuer of the bond is paid by the investor to borrow money in a negative interest rate environment. This means investors end up losing money when they hold such bonds until maturity.

In this type of bond, the issuer is compensated by the investor for borrowing money, and when investors carry such bonds to maturity, they lose money. For example, if you bought a bond that matures in three years for $103 when the par value is $100, and the bond does not pay a coupon (interest), the yield would be -.98%.

A negative yield bond exists in economic environments where the rates are negative or very low, and they are often used in developed countries to combat deflation. The UK's maiden negative conventional government bond, the 0¾% Treasury Gilt 2023, is an example of this type of bond.

The premium on a negative yield bond is the difference between the purchase price and the par value of the bond. If the premium exceeds the income the investor will receive during their holding period, the yield will be negative. For instance, if you agreed to give a friend $105 in exchange for $100 in two years, and the friend pays $2/year in interest, you'd have a negative yield.

Here are some examples of negative yield bonds:

Negative yield to maturity occurs when an investor buys a bond with a lower face value than its market price, resulting in a loss.

This is often seen in times of economic uncertainty or low interest rates, such as during the COVID-19 pandemic.

Investors are essentially paying more for a bond than its actual worth, which can be a risky move.

The bond's face value is not being paid back, but instead, the investor is receiving a lower amount, resulting in a negative yield.

This can be particularly problematic for retirees or those relying on fixed income from their investments.

The yield is essentially the return on investment, and a negative yield means the investor is losing money.

In some cases, investors are even paying to hold onto these bonds, which is a clear indication of negative yield to maturity.

This can be a sign of a broader market issue, such as a lack of confidence in the economy or a shortage of other investment options.

Negative-yielding bonds are prevalent across Japan and Europe, and individuals may own them through ETFs or mutual funds that track an index.

For some U.S. investors, foreign debt can present an investment opportunity through currency hedging premiums, if large enough to offset negative yields.

Investors can potentially benefit from hedging the local currency to the U.S. dollar if another country has a steeper yield curve.

Investors buy negative-yielding bonds because they believe the prices will keep increasing, making them a good long-term investment.

Investors are willing to accept negative yields on bonds because they are concerned about losing their principal in bad economic times.

Many investors assume that the Federal Reserve's monetary policies will eventually cause inflation to accelerate, making TIPS a good investment.

Pension funds and insurance firms often have to invest in negative-yielding government bonds due to regulatory requirements.

Investors may also buy negative-yielding bonds as a currency play, especially if their funds are in USD and they're looking at opportunities worldwide.

Negative yields can turn into positive ones with appropriate currency hedging, such as when U.S.-based investors buy European bonds and use USD/EUR hedges.

Investors buy negative-yielding bonds because they believe the government will eventually pay back the principal, adjusted for inflation.

The main reason to invest in a negative-yielding bond is risk control, as bond prices go up when yields go down.

In a crisis, investors will flee to the safety of government bonds, making them a good investment during times of economic uncertainty.

Negative yields may seem cheap in the future, especially if the years to come are dominated by secular stagnation and periodic QE injections aimed at staving off deflation.

TIPS can have negative yields because the yield on a TIPS bond is equal to the Treasury bond yield minus the expected inflation rate.

Investors get to pay someone else for the privilege of lending them money, but a negative-coupon-rate bond could still produce a positive yield if the bond's price falls low enough.

Investors may buy negative-yielding bonds as a form of insurance premium paid to the government, which may seem cheap in the future.

An active investment strategy involves selecting securities based on unique characteristics and their associated correlations to achieve a return that outperforms the index.

This approach requires a deep understanding of how different securities perform in relation to each other, allowing active managers to minimize the impact of negative yields.

By adding value to a bond portfolio, active managers can take advantage of a relative basis and tactical opportunities to outperform the broader market.

In contrast to a passive approach, an active portfolio approach is designed to outperform the bond index, not just replicate its returns.

Investing in bonds with negative yield to maturity can be a complex topic. However, understanding the different types of investments can help you make informed decisions.

Fixed income investments, such as bonds, are a type of investment that can result in negative yield to maturity. This means that investors may receive less money than they paid for the bond.

Equities, such as stocks, are another type of investment that can be less predictable than fixed income investments.

Coupon rates can be negative, which means the investor gets paid less than the face value of the bond. This can occur with a simple negative coupon rate.

A negative coupon rate can result in a negative yield, even if the market price of the bond remains the same as its face value or par value.

The market price can remain the same as face value, and a simple negative coupon rate will make the yield negative, as seen in the case of negative coupon rate and negative yield.

Fixed investments can be a reliable choice, but it's essential to understand how they work. If a bond is sold at a negative yield at maturity, the buyer won't receive back the total amount invested.

The negative yield on a bond impacts the maturity value, but not the coupon payments. This means the investor won't receive negative coupons, which is impossible.

Investors should be aware of this possibility to make informed decisions.

Floating investments can be a bit tricky, especially when it comes to managing negative yields.

Floating rate bonds, for example, can be linked to an index such as OIS, LIBOR, or EURIBOR. The reference rate paid on these bonds can fluctuate over time.

If three months EURIBOR is trading at -0.020%, it means that the spread below 20 basis points will require payments that are not possible, so there are limited options.

To manage this, investors can add a large spread at initiation, which requires a large upfront payment. This is not a popular option, as investors prefer to buy at the par rate.

Alternatively, the negative coupon can be netted against early redemption or maturity payment. This can help mitigate the impact of negative yields.

In some cases, investors may need to pay upfront costs for a floor option to protect against negative yields. This can be too expensive, making it a less desirable option.

Investors continue to purchase TIPS with negative yields because they're concerned about losing the principal on their investments.

Bad economic times are hard on stocks, so paying interest is less costly than losing everything.

Many investors assume the Federal Reserve's monetary policies in troubled economic times will eventually cause inflation to accelerate.

Investors expect the upward adjustment to counter inflation to provide a strong price performance, as it has characterized TIPS in the past.

Losing money on TIPS is possible, but it's not a common occurrence. Because the value of TIPS can decline when interest rates rise rapidly or when inflation turns downward.

Investors who buy TIPS at a high price and then see interest rates rise may end up selling their TIPS for less than they paid. This is a risk of investing in TIPS, but it's worth noting that TIPS generally help investors stay somewhat on pace with inflation in the long term.

Rapidly rising interest rates can cause the value of TIPS to decline, making it possible to lose money on them.

In times of economic uncertainty, investors often prioritize financial safety over potential returns. This phenomenon is known as the "flight to safety" or "flight to quality", where investors accept negative yields to protect their investments.

Investors may accept negative yields to avoid losses in other investments, such as stocks, during a recession. For example, in 2009, concerns about the debt crisis in Europe drove the yield on plain-vanilla Treasuries below the inflation rate.

Investors are willing to accept small losses in negative yield in exchange for the guaranteed return of principal that Treasuries offer. This is especially true during times of turmoil, such as when the European equity market was 20% below expectations and corporate bonds were defaulting.

The supply and demand phenomenon also plays a role in negative yields. In down-swinging economies, the demand for safe investments increases, allowing offerors to reduce their interest rate incentives.

Negative returns can happen even with investments that pay interest, like buying a Treasury note that pays 2% interest but has an average inflation rate of 2.5%, resulting in a -0.5% real return.

Investors often require a return, but there's a trade-off between liquidity and return, as seen with money market funds holding bonds with 13 years of maturity in the euro government debt market, which typically yields negative rates.

You'd think it's irrational to pay for holding your money, but this can happen with ordinary Treasury notes, just like it does with TIPS, where the negative yield is different due to the tie to the Consumer Price Index.

Buying bonds with lesser than 13 years of maturity can result in negative rates, making it similar to paying the issuer to safeguard your money.

Investors need to balance their desire for a return with the need for liquidity, as seen with money market funds that hold bonds with 13 years of maturity to meet client liquid requirements.