If I told you I that I would take your $10,000, invest it in bonds for 10 years, and give you back $9,999 in return, would you do it?

Of course not! But that’s exactly what’s happening with nearly $17 trillion in negatively yielding debt. Investors are buying these bonds and essentially locking in a loss if they hold it to maturity.

As the global economy continues to slow, central banks around the world have been lowering their benchmark lending rates in the hopes of stimulating their economies. Their expectation is that lower rates will encourage capital investment through lower borrowing costs. This initiative has driven up the price of bonds and pushed down their yields to extremely low, and even negative, levels.

So, who exactly is buying these bonds that are guaranteed to lose money – and why are they doing it?

Four Reasons Why Institutional Investors Might Buy Negative-Yield Bonds

Generally, buyers are institutional investors, like pension funds, commercial banks, and insurance companies, all of which have investing guidelines that they must follow – even if it doesn’t seem logical. Typically, there are four general reasons why these investors would consider buying these bonds. 

1. They are following mandated or regulatory requirements.

Most institutional investors have rules or mandates about what they can purchase in their portfolio. A German pension fund, for example, might be required to own a minimum percentage of German government bonds (Bunds) for safety reasons, regardless of yield. There also may be regulatory reasons, like a bank needing to hold certain types of government bonds to meet liquidity or capital requirements.

2. They don’t have better options.  

While a U.S. 10-year treasury yielding 1.5 percent might look attractive to a foreign buyer, after including the cost of hedging the currency (called a basis swap), the resulting rate may end up negative too.

Also, just because 10-year bonds from Brazil and Mexico are yielding close to seven percent doesn’t mean they’re a good deal.1 The volatility and potential for default from these less-stable governments may, in fact, make these bonds a deal-breaker for institutional buyers, and U.S. bonds may become more attractive as a result.

3. They are afraid rates will go even lower if they wait.

When central banks try to stimulate their economies, they often do it through bond purchases or by lowering the rate at which banks borrow funds. This is intended to encourage banks to lend more by cutting borrowing costs. If investors expect rates to go even lower, they may decide that locking in current yields is better than if they decrease even more.

4. They are playing it safe.

It might seem like putting your money under your mattress is a better option than investing in negative rates, but for large institutions with billions to invest, this isn’t an option. In fact, they are likely to pay a premium for safety and liquidity, even if it means generating a small loss.

When these investors buy high-quality government bonds, they are essentially asking them to guard their money and then give it back when promised. There is little concern that it will be lost, stolen, or that the government will default. Investors with a pessimistic view of the markets may also see the safety of these bonds as a better option compared to investing other assets that could go down much more.

If the global economy continues to slow and fears rise, the demand for “safe haven” assets like government bonds from stable governments will grow. This would push prices even higher, which, in turn, would push yields even lower than they are today. While negative rates are an odd phenomena, what’s more important is what negative rates are signaling – the global economy is struggling.

Sources:

1. “Bonds,” TradingEconomics.com, last accessed on September 3, 2019, https://tradingeconomics.com/bonds

Written by Tim Clift

Mr. Clift serves as Chief Investment Strategist at Envestnet | PMC and is responsible for research and consulting services for the organization. He leads a team of analysts who are responsible for the selection and monitoring of investment managers and a team of consultants who support institutional and advisory clients. Mr. Clift serves on PMC’s Investment Committee and is instrumental in setting investment policy for the Company.

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