A wary investor’s guide to negative yields

“Don’t panic” was written on the cover of Douglas Adams’ Hitchhiker’s Guide to the Galaxy. It was a joke meant to emphasise the wackiness of his sci-fi world. But what would be inscribed on a guide to Europe’s rapidly expanding cosmos of negative yielding bonds?

A handy guide would be well read. Actions by Swiss, Swedish and Danish monetary authorities as well as the European Central Bank have pushed overnight market interest rates into solidly negative territory — and the effects are spreading fast. The universe of negative yielding European government bonds with a maturity of more than a year is almost $2tn, according to JPMorgan.

Yet it is a world unfamiliar even to seasoned professionals. In spite of deflation and ultra-low interest rates, nothing similar happened in Japan. The unfamiliarity is generating uncertainty and worries that the impact on Europe’s financial system could be profound; instinctively, the idea that investors get back less than they lend sounds like a recipe for disaster.

“Don’t panic — yet” might be the best advice. Markets have continued to function and computer systems have not blown up. Intermediaries can still make money if there is a positive “spread” — or difference — between the rates at which they borrow and lend. As such, the dip below zero is a further slide along a continuum, rather than a journey into a parallel universe.

Confusion has grown because negative government bond yields imply finance ministries in Berlin or Stockholm receive regular payments from those lending to them. A hitchhiker’s guide to negative interest rates would helpfully point out that this is not the case.

A bond becomes negative yielding — or lossmaking if held to maturity — when the price paid to buy it is greater than the sum of the principal and stream of interest payments, or “coupons”. What has happened recently is simply that prices have been driven higher by the prospect of ECB quantitative easing, or large-scale bond buying.

“At first we thought negative yields would not last. But now the idea has become more entrenched. We have got used to the world of negative rates,” says Zoeb Sachee, head of government bond trading at Citigroup.

Theoretically, governments could introduce negative coupons. Germany issued zero coupon bonds in 2012 and the pool has since expanded. But there is no need for the administrative hassle of going a step further — and collecting payments from bond owners. The same result can be achieved through higher prices. Yields on some corporate bonds have also dropped below zero, although the figures are modest. Citigroup this week counted 53 decent-sized corporate bonds with negative yields, overwhelmingly denominated in Swiss francs.

If such trends continued, companies could make money simply by borrowing, and who would refuse a mortgage offering regular monthly payments from the bank?

We are far from that point, however. As central banks pushed interest lower, funds would eventually be withdrawn from bank accounts and kept as cash — in safes or under mattresses. Some Danish mortgages now have negative interest rates. But administrative charges mean customers still have to pay; Nordea bank says it will not issue new mortgages with negative interest rates.

Instead, those enjoying negative yields are those who do not want to borrow more — fiscally cautious governments and banks that are already awash with central bank liquidity and are charged when they deposit money at central banks. Although Sweden’s Riksbank made history last week by pushing its main policy rate below zero, its “repo” rate nowadays is not the rate at which it provides liquidity but the rate at which it withdraws liquidity from the financial system. (If this makes you feel as if your brain is being eaten by a Bugblatter Beast of Traal, you are not alone.)

All the above does not mean negative interest rates are harmless. If sustained, they will add to the problems for pension funds and insurance companies struggling to match returns with liabilities. While it still makes sense for some investors to buy at negative rates, they will push others into ever riskier assets. Negative interest rates also blow up calculations of the value of future cash flows used, for instance, by equity investors. But such worries applied when interest rates were crashing towards zero. The negative universe is scarier than the positive interest rate world — but not so different.

ralph.atkins@ft.com