There is a new talk in the town: Bonds that cost investors the money. In short, losing money deliberately. According to the latest Bloomberg report, the bonds with negative yields touched ~USD 13 trillion up from ~USD 8 trillion a year ago. But before we move ahead, we should take a look at what constitutes a negative yields bond.
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Say, a bond's face value is $400 and the coupon rate is 2.5%. This means that the investor would get $10 every year as an interest. The current yield of the bond (CY) is 2.5% ($10/$400). Now the bond prices move according to supply and demand in the market.
There is yet another term called Yield to Maturity (YTM). YTM is simply IRR for all the coupons which the investor receives over the period of bond maturity. For eg. if in the above example the maturity period is 5 years, the investor would pay $400 at t0 to buy the bond. He/she would receive $10 each year till t5 and additionally $400 at t5. The IRR of this cashflow is 2.5% and hence YTM is equal to 2.5%.
When the central bank decreases interest rates, the bond prices move up. The reason for this is that since the new government bond is issued at lower interest rates. And the bond in our example becomes more lucrative to the investor who might pay more than $400 to receive current yield of 2%. Hence CY and YTM decreases. The reason is same for the vice versa scenario,i.e., when interest rate rises, the bond prices falls and hence current yield and YTM rises.
Now from the above explanation, it is clear that YTM falls to 0 when the sum of all coupons and the final amount (face value) which the investor receives at the end of maturity is equal to initial investment which the investor makes. YTM becomes negative when the investor pays more than the sum of all coupons and the final amount (face value) which the investor receives at the end of maturity. But why do an investor invest in such type of bonds?
The question arises "Who would buy these bonds?" The corporations & investors, which have huge hordes of cash, need to invest the cash in a low risk highly liquid instruments which the government bonds certainly provide. However, they do not invest in stock markets, since there is a high volatility situated with stock markets and there is no fixed payments at fixed time intervals.
Central banks have kept interest rates extremely low and hence brought down yields to the extent that they have become negative. The reason for this predicament is that they are trying to revive the economy which is experiencing the fear of deflation. Apart from lowering interest rates, they had earlier initiated what is known as Quantitative easing (QE) program. For the beginners, QE refers to the process where the central bank pumps the money in the economy by buying long term government securities. This induces demand and encourages lending in the economy. One school of thought why all these measures have not worked is that the Europe has exhausted its demographic dividend and thus its working age population has declined to an extent that the demand has not been able to spur despite repeated rescues. The same situation occurred in Japan during what is now famously known as "The Lost Decade"
This situation has led to companies not undertaking capex since they foresee muted demands and the current capacity lying idle. This has led to shortage of borrowing. This situation can create a vicious circle where fall of demand induces companies to not invest further which further leads to fall in real wages and thus fall in demand.
The ideal way to overcome this problem is to induce government spending since the private sector is wary of taking loans. This spending can be used to kickstart the economy. However, the debt levels of European central banks are already so high (due to QE) that they cannot borrow the money to invest in the economy.
Another way to kickstart the economy is what is known as "The Helicopter Drop", i.e. print more money and directly give it to consumers to spend, which is equivalent to saying that drop the money from the sky. The reason that the economy might resort to such a measure is that the corporations are unwilling to spend and hence unable to spur the demand. Hence the government steps in and distributes money directly to people to revive the economy.
In the long run, how would governments around the world react. We have to wait and watch at last.
Do check out the amazing commentary by Raghuram Rajan on prospects of world recession (https://www.bbc.co.uk/programmes/p07h752y)
Special Mention: Inputs taken from my batchmate Ganesh, who is popularly know as GSN in his friend circle (Linkedin Profile)
This situation has led to companies not undertaking capex since they foresee muted demands and the current capacity lying idle. This has led to shortage of borrowing. This situation can create a vicious circle where fall of demand induces companies to not invest further which further leads to fall in real wages and thus fall in demand.
The ideal way to overcome this problem is to induce government spending since the private sector is wary of taking loans. This spending can be used to kickstart the economy. However, the debt levels of European central banks are already so high (due to QE) that they cannot borrow the money to invest in the economy.
Another way to kickstart the economy is what is known as "The Helicopter Drop", i.e. print more money and directly give it to consumers to spend, which is equivalent to saying that drop the money from the sky. The reason that the economy might resort to such a measure is that the corporations are unwilling to spend and hence unable to spur the demand. Hence the government steps in and distributes money directly to people to revive the economy.
In the long run, how would governments around the world react. We have to wait and watch at last.
Do check out the amazing commentary by Raghuram Rajan on prospects of world recession (https://www.bbc.co.uk/programmes/p07h752y)
Special Mention: Inputs taken from my batchmate Ganesh, who is popularly know as GSN in his friend circle (Linkedin Profile)
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