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24 March 2015

Understanding Negative Yields 

It is a measure of Ireland’s phenomenal recovery that it has now become the latest country to issue short-dated sovereign debt at a negative yield – meaning that investors sacrifice a return on their money in exchange for security. This week saw Ireland offer €500 million worth of six-month debt at a yield of minus 0.01%, guaranteeing investors a loss if they hold the bonds to maturity.

This is not a new phenomenon. Germany sold five-year bonds at a negative yield (-0.08%) in February this year. The secondary market now has all German bonds with a maturity of less than seven years on a negative yield. The 10-year bund yield is just 0.31%.

In addition to some members of the eurozone, Japan, Denmark, Sweden and Switzerland all have negative yields on their debt. In fact, around 25% of the BofA ML Euro Government Index by volume is currently at a negative yield.

Why would anyone buy a bond with a negative yield, and why were the recent bond auctions for Germany and Ireland over-subscribed? It may make sense to buy a bond with a negative yield in the event of deflation. The fall in oil prices has sent cost-of-living indices around the globe into reverse. Large parts of Europe have seen consumer prices fall over the past 12 months, and some analysts expect Japan to join them.

However, caution is justified – it may be a mistake to think deflation will last very long. Eurozone economic data has been improving as the impact of lower oil prices, the declining euro and some relaxing of fiscal conditions takes hold. Quantitative easing – recently launched by the European Central Bank – also appears to be helping to spur growth.

Fears that Europe might become trapped in a deflationary spiral, like Japan’s ‘lost decade’ of the 1990s, might, therefore, be misplaced. A resurgence in inflation would make the phenomenon of negative yield bonds short lived.