Let’s get one thing clear: Negative bond yields are bizarre. As “things you have to explain at cocktail parties go,” it makes explaining the money supply seem like kindergarten.
And yet negative bond yields are a real thing. The number changes every day as the prices of low-yielding bonds fluctuate, but somewhere on the order of $3 trillion in bonds is currently in negative territory.
How Does This Even Happen?
Well, when an issuer like a company or government wants to sell bonds, it’s just a supply and demand problem. If, say, Germany wants to float some bonds, it’ll seek to pay as low a coupon on each bond as it can. Investors, on the other hand, rationally will seek the highest coupon they can get.
This all shakes out in the market through an auction, where people bid on the new debt the issuer is offering.
So how do things go negative? Well, first off, to my knowledge, there is no such instrument as a bond with an actual negative coupon payment. You can’t buy a bond for $100 and then mail the Bundesbank a check every quarter.
Instead what happens is the Bundesbank says, “Here’s a bond that will be worth $100 in five years when we pay it back. It pays nothing. How much will you buy it from us for?” In other words, it’s a zero coupon bond.
Now the market jumps in and says, “I’ll buy it for $101!” and voila, you have negative yields. You’ve just guaranteed a repayment of $100 for the low, low price of $101.
Of course, because governments are issuing bonds all the time, the implied yield of all the bonds that just happen to come due in five years will reflect that behavior, which is why bonds are almost always quoted in the press simply by their yield, not their par values and coupon payments.
Why Would Anyone Do This?
There are a host of reasons that an investor might want to pay for the privilege of owning a German five-year note. As a U.S. investor, buying a euro bond is a pure currency play—you’ll make money if the euro rallies. That’s part of what’s behind the negative yields, for instance, in the now free-floating Swiss franc. And even with a negative yield, if the economy goes into deflation, your negative yield is still positive in real terms.
So why not just hold cash? The short answer is that if you were a rational actor with no concerns about the safety of your cash, you would. You’d just stick bills in a vault.
But many, many institutions have rules that make this a virtual impossibility. The average institutional investor who wants safety actually can’t just leave it all in the cash account at their custodian, because banks aren’t guaranteed. They can and do go bust from time to time. Just look at how Greek investors have been withdrawing their cash from Greek banks.
Even here in the U.S., if you leave $1 million in cash at Citibank, you’re not actually backed by the FDIC past $250,000. For this reason, almost all institutions use short-term bonds for their “cash” holdings; in many cases, under strict rules—in other words, they have no choice.
The Index Problem
There’s another category of people who don’t have a choice: indexers.
I’m a died-in-the-wool indexer, but sometimes they lead to unintentional exposures. Consider the iShares 1-3 Year International Treasury Bond ETF (ISHG | B-78). Its mandate is to track the S&P/Citigroup International Treasury Bond Index Ex-US 1-3 Year index.
There’s simply no way for this fund not to end up buying one- to three- year bonds from Germany—it’s in the index rules. And that means they’re a natural buyer of negative-yielding bonds, like it or not.
The overall impact on the portfolio is just what you’d expect. A trip to the iShares website shows the 30-day SEC yield (a backward-looking 30-day measurement of portfolio yield) for ISHG at -0.15 percent.
Its overall portfolio yield to maturity (the expected yield just from holding the bonds it has right now till maturity) is ever so slightly positive, at 0.09 percent—but that doesn’t include any fees, which are a hefty 0.35 percent.
So why might you, as an ETF investor, decide to invest in ISHG? Well, there’s about $135 million worth of investor money in it right now. Some of that money may have the same constraints as institutions. Some of it may be betting on a run in the euro.
And some of it? Well honestly, some of it may just not be paying attention. Which leads to the moral of the story, which is pretty much always the moral of the story: Know what you own, and know why you own it.
At the time this article was written, the author held no positions in the securities mentioned. You can reach Dave Nadig at [email protected], or on Twitter @DaveNadig.