In certain situations, those holding bonds with sub-zero yields could actually come out ahead
Given the traditional role of fixed income in a portfolio, investors will most likely find it impossible to wrap their heads around how negative-yielding debt works, much less the investment case for it. But it can actually serve as a reasonable solution to certain problems.
One possible application would be to get a modest amount of security. In an interview with the Wall Street Journal, CFRA Chief Investment Strategist Sam Stovall said that negative-yielding bonds that have a miniscule risk of default may appeal to some investors looking to protect their initial investment.
“Think of the negative yield as the cost of storage,” Stovall said. “Would you rather pay nothing for questionable security, or would you rather pay a little bit more to ensure your principal is safe?”
Going by recent figures on the AAA-rated 10-year German bund, the “cost of storage” would be 0.5% a year. Under normal circumstances, simply keeping one’s money in a deposit account with zero or ultralow interest would be preferable. But that can change in a situation where financial institutions pass on the costs of negative interest rates to deposit customers, which some European banks already do.
Negative-yielding debt could also present an opportunity to traders, according to the Journal. Since fixed-income prices and yields move in opposite directions, a bond yield that sinks deeper into negative territory would result in a rally in the bond’s price. A trader that believed in such an outcome might therefore consider buying a negative-yielding bond.
People who invest across borders might also want some negative-yield bonds in their portfolio, particularly to offset certain changes in a currency’s value. Going back to the example of the 10-year German bund, its -0.5% yield would ordinarily make it the natural loser in a head-to-head against the 10-Year U.S. Treasury, which has a 0.7% yield. But given the rally in the euro that brought its exchange rate from US$1.10 to US$1.17 over the six months beginning on March 30, a U.S. investor who bought the bond at the beginning of that period would have found themselves better off even given the difference in yields.
But David Ranson, director of research at financial-analytics firm HCWE & Co, sounded a note of caution on adopting that strategy, telling the Journal: “You’d be putting an awful lot of weight on something that hasn’t had a long history.”
And while negative-yielding securities would normally present a thorny portfolio-management problem, that might not be the case if an investor were forced to choose among peers of similar quality and even worse yields. But such opportunities are fleeting as investors would quickly take advantage of such discrepancies.
Finally, negative-yielding debt could make sense in a deflationary environment. If a one-year bond were to offer a -5% yield but inflation was forecast at -10% over the same period, investors in the bond could still come out the other side with more purchasing power as the prices of goods and services fall faster than the drop in value of the fixed-income security.
“You can have negative interest rates at any level as long as the expected inflation rate justified,” Ranson told the Journal.