When you lend money to the government by buying a Treasury bond, it’s an investment and not a favor. You expect to get back more than you put in, in the form of interest, in order to compensate you for a multitude of risks and the loss of use of your money. This makes recent news about the proliferation of negative yielding debt (shown in red below) seem perplexing.
Yield and price work like a seesaw; the more you shell-out for a bond’s fixed payments, the lower the return on your investment. A negative yield implies that demand has driven the price of bonds so high that you’re actually paying to lend money. Surely, no one would take this offer – or would they?
The world’s negative-yielding debt totals a record $15 trillion today. There are a number of reasons for this seemingly irrational accumulation, but most of them have to do with at least one of two things: pessimism about the future and the desire for safety.
Many large institutions – such as pension funds – are mandated to keep a certain percentage of investments in their government’s debt, so they must continue buying regardless of price. This makes sense from a safety and liquidity standpoint. If you need money to pay future liabilities, a bond from someone who can raise taxes and print money to avoid default is a solid choice, even if there’s a chance that you’ll get a small negative return.
Another factor is the expectation of future deflation. Deflation occurs when prices fall due to a lack of demand for goods and services, usually when economic conditions significantly deteriorate. The implication of negative-yielding debt is that even though you are getting fewer dollars back than you invested, those future dollars will still have increased purchasing power as long as your return drops less than the general level of prices.
Also firmly in the category of a less-than-rosy outlook, is the chance that negative yields could continue to slide even farther below zero, making today’s small loss more attractive than a potentially larger loss in the future.
So, what can we take away from all this?
Negative rates can be a boon for some and a hardship for others. Borrowers are generally rewarded; one Danish bank is actually paying people to take out mortgages. Savers are punished by having to pay banks to hold their money or by falling short of expected returns. In general, negative rates can be seen not only as a signal but as a potential accelerator of a deflating economy, which can be hard to escape once entrenched. Negative rates can stifle investment as people without attractive options keep money in cash, but can also have the perverse effect of increased risk-taking as people reach for yield in unwise ways – both actions that can cause larger ripple effects on the system.
The impact of the current negative rate environment is unclear. It could be the spark that jumpstarts a sluggish world economy temporarily spooked by trade issues and geopolitical risk. Or it could be the sign of a new normal: slow-to-no growth in advanced economies due to underlying demographic and technological trends. Only time will tell if it’s sustainable, but for now the U.S. continues to look good if only by comparison, with economic growth and yields that remain low, but at least positive.
