Why buy negative yielding bonds?

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Hello. I'm here to make you an offer. You lend me £100. And I will pay you back £90 in 10 years' time. So yes. You lose £10 on my offer.

It doesn't sound like a good investment at all, does it? But this type of arrangement has become strangely normal in the markets, particularly in Japan and Europe. So how did things get so topsy turvy? Let's start with the basics.

When companies or governments need to raise money they have two options. Governments can issue bonds. And companies can - on top of that - also issue shares to investors. But what we're interested in are bonds.

They're a form of debt that can last over different periods of time, from a few weeks to several decades. And unless something goes seriously wrong, you will get the full amount that you have invested.

So this is how it works. The issuers of the bonds will make regular interest payments to those that hold them over their lifespan. This fixed rate of return investors receive on a bond is called the coupon.

On top of this, there's an extra component, this payment - as a proportion of the price - is called the yield. It's the price of the bond changes so does the yield. The lower the price goes, the higher the yield rises. And the higher the price goes, the lower the yield falls. You get the idea.

Now a negative yield is the opposite. It means investors are receiving less money than they originally paid. And what is so topsy turvy in the markets today is that roughly a fifth of the global bond market now trades at negative yields.

So why is this happening? Let's go back a bit. In the last decade or so, developed economies have suffered from low growth and low inflation. So to encourage people to spend more money, central banks have been reducing interest rates and injecting money into the economy through quantitative easing, or QE, to make individuals like us less motivated to keep money stored in our bank accounts and instead spend it or put it in riskier assets.

And the same is applied to the banks. The European Central Bank, for example, now charges other European banks nearly half a per cent interest to hold their money in their deposits. Because it wants banks to lend their capital out into the economy rather than just sitting on the couch.

So far we've been talking about ordinary people like you and me. Now let's move on to investors, a particular subset - investors with loads of money to spend. If you were one of these investors surveying the markets right now, this is what you'd see.

Bond prices have been skyrocketing. And that's happening because investors still see bonds as some of the safest assets when the economic outlook is poor. And so they have been buying them, as well as central banks.

And as the bonds get more expensive, the returns become much lower. The prices are now so high the yields in a number of countries - such as Austria, Belgium, Denmark, Finland, France, Germany, Japan, the Netherlands, and Switzerland - have gone below zero. So investors are certain to get back less than they paid if they hold the bond to maturity.

So why hold these bonds at all? In this topsy turvy world, issuers of debt are now being paid to borrow. And the investors, or buyers of bonds, are paying cash to these borrowers, companies, and governments instead of receiving an interest payment.

But despite the strange world for investors, as we said, bonds are seen as one of the safest investments on the market. Because their returns have been very reliable they're at the heart of most portfolios.

Government bonds, in particular, are considered very safe assets because governments are reliable borrowers. The owners of these bonds, or gilts, can also buy and sell them in what is called a secondary market. This makes these bonds very liquid, to continue the financial jargon.

Of course, bonds are only safe investments if their rates are positive and above the rate of inflation. Otherwise, investors won't be earning any money, as is happening with bonds with negative yields. And that has kicked off a very active debate about whether government bonds should be considered as safe havens at all. In fact, some investors are refusing to own negative yielding debts for this reason.

But for really big investors - such as banks, insurance companies, and pension funds - they have no choice. They have to own bonds, even if the financial return is negative. This is because they have to make sure their funds are liquid. And when borrowing, they can also pledge bonds as collateral.

So this is where we are now. But what next? It depends. If low growth, trade tensions, and political uncertainty continue investors are likely to continue to flock to safer assets, like government bonds, thereby driving up prices and keeping yields on the negative.

In fact the volume of negative yielding bonds has started to fall. But some market experts still believe that until at least 2022, about a fifth of sovereign bonds will have a negative yield.

But back to you, in this topsy turvy world, how does this affect you? In the short term, it seems that negative yields can actually get the economy moving. But over the long term, negative yields could mean lower returns on pension funds, meaning workers could be forced to save more and work longer.

We are already seeing signs of this, especially in eurozone countries where people have become concerned about not receiving positive returns and have started to set more money aside for the future. The central banks believe their strategy can help the economy. But their critics warn that negative yields could slow down the economy even more. And the central banks could find themselves trapped by their own policy of cutting borrowing rates below zero.