Understanding negative yields

When people deposit money at a bank or purchase a bond there is normally an expectation that you would get your principal back plus some interest.  What is occurring in Europe now is that in some countries it will actually cost you money to invest in government bonds.

An informed investor knows that there is some principal risk when investing, even in “safe” government bonds.  That risk being, should interest rates rise after you purchase a bond, and you later sell the bond before maturity, you can have a loss.

However, the situation in Europe is such that you will actually have a negative return on some government bonds that you hold to maturity.  Someone is making the purchase with the expectation that he/she will lose money.  That is different from the situation where you have a loss because of a change in interest rates, and you sell before the bond matures.

A reasonable person might think, what kind of investor would be willing to accept such terms? After all, someone would be better off just holding on to their cash rather than investing in a government bond. There are some circumstances where there is some logic in accepting the negative yields.

For example in Switzerland government bond yields are negative out to 10 years.  However, Switzerland has a very strong currency due to their sound money policies.  Therefore, a foreign investor could still garner a positive return, if the Swiss Franc appreciates relative to the Euro or the U.S. Dollar.

In Germany government bond yields are negative through five years, and just barely above zero at 10 years.  Germany is in the Eurozone, but it has the strongest finances of the countries tied to the Euro.

For a large European investor, obviously they will not want to keep all of their money in cash, so for safekeeping accepting a small negative yield still makes sense.  In addition there are some active traders who believe that the current negative yields could fall even further.  Therefore, they could make a profit on a bond trade, if that scenario takes place.

Someone might wonder how interest rates in Europe got to the point of turning negative.  The first reason is that the European Central Bank has been buying government bonds in hopes of stimulating the European economies, which has lowered interest rates.  In addition the turmoil in Greece has led to investors to park their money in countries with the strongest financial systems, notably Switzerland and Germany.

The actions of the European Central Bank do appear to be working to some extent.  We are seeing some signs of economic growth in Europe after a number of countries had been in a recession.  Also, most of the stock markets in Europe this year have performed well.

Because interest rates are so low in Europe and also Japan, yields in our country by comparison look relatively attractive. That is with the 10-year U.S. Treasury yielding only around 2 percent.  With our inflation rate running at just under 2 percent, a U.S. investor is essentially getting a 0 percent real yield.

It is difficult to say how the situation in Greece will ultimately be resolved. For the time being this environment of negative interest rates in Europe will probably continue for a period of time. Ultimately, as the European economies recover and the situation in Greece is resolved rates will become positive once again.

In the U.S., besides the developments in Europe, the fixed income investor needs to be cognizant of what the Federal Reserve will do.  The expectation is that the Fed will start raising interest rates sometime later this year.  While interest rates should stay low here for a while longer, as Europe stabilizes and the Fed raises short rates, long rates will likely rise too.

Because interest rates are so low throughout the world, that has created a positive backdrop for stocks.  Assuming moderate economic growth throughout the world this year, and given the current interest rate environment, the outlook for stocks appears to be somewhat better versus bonds.