The Handbook of Fixed Income Securities by Frank Fabozzi, widely considered to be one of the most trusted resources for bond investing, has no mention of negative yields in its 1,803 pages. And yet today, negative yields are pervasive around the developed world; in many ways this is uncharted waters for bond markets. For investors, the arrival of negative yields may seem paradoxical, and many have questioned how something theoretically impossible can now be so wide-spread. In this paper, we address five of the most pressing questions on negative yielding bonds and discuss their investment implications.
How do negative yielding bonds work?
Negative yielding bonds are theoretically nonsensical: an investor that purchased one and held it until maturity would effectively guarantee themselves a loss. But how does negative yielding debt work in practice?
Negative yielding bonds are not issued with a negative coupon, which would force the lender to pay a coupon to the borrower, a complex structural arrangement. Instead, negative yielding bonds are issued with a zero or just-above-zero coupon, but their selling price is higher than face value.
To put this in more practical terms, let us consider a real life example of a 30-year German bund. The bond was auctioned in August 2019 with a coupon of 0% and with a face value of €100. However, at the initial auction the bond sold for €103.61. As the price of the bond exceeded its face value, the bond effectively traded with a yield of -0.11%.
Who invests in negative-yielding bonds?
Ownership of negative-yielding debt can be broken down into two distinct groups: forced buyers and speculative investors.
Forced buyers are profit-agnostic: they are holding the bond for a reason other than making a profit. One example of a forced buyer is a central bank buying bonds in order to achieve asset purchase targets. In places like the eurozone and Japan, for instance, central banks own 21% and 48% of their own outstanding government debt, respectively.1 Another example of a forced buyer is large financial institutions required to hold high-quality debt to meet capital requirements set by regulators.
Speculative investors, on the other hand, hold negative-yielding instruments in an attempt to profit off of price appreciation, but do not look to hold the bond to maturity. Investors like hedge funds and traders, for example, may attempt to buy a negative-yielding bond, assuming that yields may fall further, thereby making a small profit. Speculative investors can also include those holding negative-yielding debt because they are nervous and willing to pay the government for protection. In reality, this subset is likely to be quite small, as nervous but rational investors would likely prefer to hold other safe haven assets like gold rather than guarantee themselves a loss.
Unfortunately, there is no exact data series on the global ownership of negative-yielding debt. Instead, Exhibit 1 identifies and quantifies debt ownership in one particular country: Germany. As all maturities of German government debt trade with a negative yield, we can use this as a proxy for estimating the positions of the different bond investors. In this instance, forced buyers of German debt include central banks, the domestic banking sector and other financial corporations like pension funds. By this definition, approximately 40%-50% of the holders of German government debt are forced buyers. The remaining 50% of debt holders are “non-residents,” and while a detailed breakdown is not available, this group likely includes hedge funds, sovereign wealth funds, traders, investment funds and pension funds. These holders are likely motivated by the potential for profit on falling yields.
EXHIBIT 1: Breakdown of German government debt by ownership
Source: Bruegel, J.P. Morgan Asset Management. Data are as of September 9, 2019.