Why do Investors buy Negative Yield Bonds?

Published by Ecosodes team on

Generally, when anyone invests a sum of money in a particular asset, the intention lies to earn something out of it or use it for a purpose which yields the individual a profit. Here you might be wondering then, that why can someone actually invest in a Negative Yield Bond. We will discuss that in detail below. But. before that, it is imperative to understand how does a bond work.

A bond is an asset class where an investor invests in a bond for a particular period and gets the face value of the bond at the end of the maturity period.

The maturity period refers to the time period between when an investor invests a sum of his amount and when he/she gets the principal amount repaid. Additionally, an investor gets an annual interest on the face value of the bond as per the
coupon interest rate.

For example, let’s look at Bond ABC with the following characteristics:-
Maturity period – 3 years
Face Value – $100
Issue Price – $90
In this case, the investor invests $90 in Bond ABC and at the end of 3 years will make get $100 in return, thus making a profit of 10 dollars.

For an investor to earn a profit, it’s not necessary that the issue price should always be less than the bond price, bonds can also be issued at a premium. Over and above the return an investor gets at the maturity date, he/she gets an annual interest on the face value of the bond as per the coupon interest rate.
For example, let’s look at Bond XYZ with the following characteristics
Maturity Period- 3 years
Face Value – $100
Coupon Interest Rate – 5%
Issue Price – $105

In this case, even though the investor gets $5 less at the time of maturity in comparison to the amount invested but gets an interest of $15 ($5 * 3). Therefore, earning a profit of $10 or we can say that the issuer of the bond pays $10 to the investor for investing $105 in bond XYZ.

Now let’s look at an example where the investor is incurring a loss. Consider Bond WXY with following characteristics
Maturity Period – 3 years
Face Value – $100
Coupon Interest Rate – 5%
Issue Price – $120

This Bond is similar to Bond XYZ studied above, the only difference being that the issue price is $120 instead of $105. So in this case, the investor gets $20 less than the amount invested, and out of $20 only $15 is compensated by interests. Thus, investors incur a loss of $5 or we can say that the investor is paying $5 to the bond issuer.

Such a bond where the investor has to pay the bond issuer and suffers a loss instead of income is called negative yield bonds. Even after being a loss-making asset, some of the investors still invest in negative yield bonds and there are numerous distinct reasons for the same.

First, investment firms buy because they have to allocate a portion of their assets to bonds in order to create a diversified portfolio. A diverse portfolio means having a group of investment assets that have different risk levels and yields. So by allocating a portion of the portfolio to bonds, firms tend to reduce the risk from other financial assets, even if these bonds yield negative returns.

Second, bonds are often used to pledge as collateral to the lender in order to borrow funds. So one has to hold some bonds, regardless of the price it yields.

Third, investors may invest in negative yield bonds and can compensate their negative yields through an increase in the price of the domestic currency, i.e,
an increase in the foreign exchange rate. For example, an Indian investor invests in a bond having a face value of $100, issued at $105 with a 0% coupon interest rate. At the time of issue $1=₹70, so the investor had to pay ₹7,350 (105 * 70) to purchase the bond. At the time of maturity, the price of domestic currency increases
to 1$=₹75. Now the return from the bond is $100, which when converted to Indian currency gives a return of ₹7,500(100 * 75). Thus, even though the yield from the bond was negative the investor was able to make a profit of ₹150.

Fourth reason being, domestically the investors might expect deflation in the economy in the future years. Deflation means a decline in the price of goods and services. In this case, the amount saved by the investor by locking in the bonds for the maturity period permits him/her to buy more goods and services.

Lastly, an investor might be interested in buying a negative yield bond because they believe that the loss would be comparatively less than in other investments. In times of economic uncertainty, it can be used by investors as safe-haven-assets and such
purchases are called flight-to-safety-trade in the bond market

Written By – Raunak Agarwal
(Raunak is currently a second-year student at Shri Ram College of Commerce)

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