Why are market interest rates negative? And why are investors willing to invest in them?
Monetary policymakers’ longstanding tool to ensure sustainable economic growth and maintain prices is the interest rate at which banks borrow overnight. Central bankers lower this rate to stimulate a sputtering economy—which encourages banks to lend, investors to borrow, and consumers to spend. Conversely, the rate is raised to tighten credit markets—slowing inflation and growth. However, the post-financial crisis world has diminished the overnight rate’s efficacy. From the need for a stronger tool to influence the economy, Quantitative Easing arose. QE is a policy tool where central banks buy securities with printed money, thereby increasing the money supply and price level, while lowering interest rates and subsequently encouraging lending and spending. QE has had mixed success in terms of economic stimulus, inflation, and currency effects. However, by its nature, QE drives down interest rates as demand for government securities (or corporate credits, ABS, etc.) rise. In theory, this credit easing produces economic flourishing—raising investment, employment rates, and consumer confidence.
As central bankers chase this unicorn, they’ve driven many overnight and market-determined rates through the supposed zero-bound and into negative territory. This negative yielding debt doesn’t represent a small, illiquid corner of the sovereign debt market either. Bloomberg published in October that the nominal value of all negative yielding market interest rates was $11.6T USD (chart above). Yields on Japanese government bonds (JGB) have remained negative throughout 2016 and into 2017; the current JGB 10 year yield is -0.05%.
So why would an investor buy a negative yielding bond and hold it to maturity, when he will surely lose money? We know that a rational investor, looking to optimize risk and return, wouldn’t invest at all. Yet the reason negative yields exist is because the secondary market allows investors to speculate on price movements from a changing landscape of economic conditions, geo-political risk, market expectations, interest rate changes, etc. Therefore, one hypothesis is that investors don’t invest in negative yielding debt to take a loss; instead, they’re hypothesizing that bond prices will continue to rise.
We will continue to examine the different factors that investors believe will cause bond prices to keep rising, and therefore lead them to invest in negative yielding bonds—but first, an examination of why not all investors are rational investors. Many institutional investors who run pension funds, fixed income funds, etc. are required to allocate a certain proportion of their portfolio to sovereign debt that meets certain standards, or are required to create portfolios that track certain bond indices. These rigid requirements force investors to hold negative yielding assets regardless of investors’ price targets and motivations. Similarly, in periods of economic uncertainty, investors prefer stability to returns. Given that Japanese bonds (as well as most other negative yielding fixed income products) are considered safe haven assets, volatile periods are another example that defies traditional economic theory and may lead investors to prefer a negative yielding bond. This holds true if investors’ expected return on a portfolio partially consisting of negative yielding bonds is greater than the expected return of a portfolio without the bonds.
However, these exceptions aren’t the key drivers behind negative market interest rates and the sentiment that negative rates aren’t going away anytime soon. So what are the drivers keeping prices at uncommonly high levels? Most significantly, the overwhelming sentiment is that the global economy’s fundamentals are soft—emerging markets are debilitated from commodities’ slide and recent dollar strength, Chinese global demand is weakening as it undergoes fundamental changes to its economy, and investors fear that changing oil fundamentals (i.e. fracking) will soon tap out its price recovery. In the face of economic weakness, monetary policymakers will continue quantitative easing and cutting deposit rates. One of the many qualms economists have with QE is shown in the image below—the program doesn’t work perfectly. Although traditional economic theory suggests that QE leads to lower interest rates, currency appreciation, and inflation, Japan has only experienced one of these effects. Because policymakers have a limited number of tools, one could argue that some central banks are over reliant on QE, leading to artificially low yields.
Investors also must factor in fixed income securities’ yield against price level and currency expectations. If the negative yield an investor receives isn’t as negative as deflation, the investor would receive a positive real return. Therefore, nominal yields don’t tell the entire story behind why an investor would consider a negative yield. Although a complex trade, losses from buying negative yielding foreign debt can be offset by greater appreciation of the currency that the debt is denominated in.
Investors should familiarize themselves with negative yields, because they are new norm in today’s global economic climate. Understandably, when taken at face value, negative yielding securities don’t seem like a rational investment. However, given the structure of financial markets, there is always an opportunity to make a profit off of price inefficiencies; and where there are price inefficiencies, there is bound to be an investor.