bank of Japan

Bank of Japan

For quite some time now, several governments started issuing bonds with negative interest rates. Our gut dislikes negative interest rates. First, how could a negative interest rate even exist? And Why would anybody be fool enough to pay an interest rate in order to lend money, i.e. to take a risk without apparent reward? Truth is, many investors purchase this securities, but the underlying reasons differ.

A bit of economic theory

In finance and economics theory, we can break down interest rates as follow:

Interest rate = Real Interest rate + inflation premium + default risk premium + liquidity premium + maturity premium

Let's take a look at government bonds with negative interest rate:

  • Typically, negative interest rate bonds have a short maturity, thus a low maturity premium, as it is not needed to reward investors for long-term risks if they purchase short term securities.
  • The liquidity premium is also very low: there is a huge secondary market, which means that it is easy to sell such securities.
  • The default risk premium is also rock-bottom low. Governments are the most reliable economic agents when it comes to solvency. They sometimes default, but it is assumed that large western government will not default on their debt.
  • The inflation premium is also very low, as inflation is typically low in countries which issue negative interest rate bonds (see more below)
  • Finally, the real interest rate, which consists in an opportunity cost (I lend you money, therefore I cannot consume now, nor can I invest in other things) is also very low: in a very volatile environment, where a lot of political and economic risks are present, government bonds act as a safe haven. Thus it is not shoking to pay to hold them.

In short, negative interest rates are fully compatible with the economic theory. Which is all the better as we can see them with our own eyes in real life. Let's now take a look at who precisely are the investors who buy such securities.

Regulatory pressures

Since the 2007 financial crisis and the fall of Lehman Brothers, authorities have tried to enforce regulations to ensure the stability and resilience of the financial system. Part of these regulations consist in forcing the banks and insurance companies to hold liquid assets to back their lendings. These assets must be liquid, and carry a very small risk: their goal is to protect the bank against illiquidity or unsolvency, not to generate a high return or to increase the bank's risk.

Only a limited number of securities are eligible to be part of these risk-free liquid assets. Paramount are government bonds. This create a huge distortion in the market, as major banks have to hold government bonds, no matter their return, only for regulatory purposes.

What is more, the huge demand generated by these institutions drive the interest rates lower. Indeed, a higher demand for bonds translates into lower interest rates, as issuers can offer less favorable terms and still find buyers for their bonds.

The role of Central Banks

But the commercial banks are not the only ones who do not really care about the return and buy no matter the yield. the biggest players in that field are the central banks. The ECB buys €80bn in securities each month. The BoJ (Bank of Japan) holds $2.7tn (¥2,955tn) in Japanese government bonds as of 31st March 2016.

The objective of the Quantitative Easing policy implemented by these central banks is to increase the money supply in the hope of propping up the inflation and to pump up the economic activity. The fruits of this policy seem to take time to mature: inflation in 2015 was 0.2% in the Euro area, and 0.8% in Japan. The economic growth is also stable at low level in these two regions. Nevertheless, Central Banks try to increase both the size of their intervention, and its scope, regurlarly adding new securities to the pannel of eligible instruments that they can purchase.

In addition to this massive intervention, Central Banks also hold Bonds as part of the foreign exchange reserves, alongside cash, gold and other financial instruments. For example, the ECB holds a large amount of debt instruments as part of its reserves (about €200bn), mainly denominated in US dollars and Japanese Yens (policy statement). This practice also increase the demand for bonds, and thus decrease the required return.

Betting on Currencies

Though the Central Banks and commercial banks subject to heavy regulations might represent the largest part of the demand for negative interest rate bonds, other can also have an interest in purchasing such securities. One kind are investment funds with a global macro strategy. These funds try to generate a return by forming accurate expectations about economic data, which reflects on financial markets, and in particular on currency movements.

For example, some investors might want to bet that the Japanese economy will recover, the domestic demand increase, and that the Yen will thus appreciate. To take this bet, a fund could simply buy Yens. But it is not that simple. The investment policy of the fund might not allow it to hold a large amount of cash. Therefore, the fund will want to buy highly liquid assets denominated in the desired local currency. Government bonds are a very good fit: there is a large secondary market with huge buyers (the Central Banks and commercial banks) contributing to the liquidity of the instrument. Even if the interest rate on the security is slightely negative, the fund could still make a profit. As a matter of fact, the Japanese Yen has been one of the top performer in 2016: an investor who bought Yen as at 31.12.2015 would have made a return of about 6.9% as of today (that is, close to an annualized return of 25%). Strategies betting on a break-up of the European Union might also involve government bonds. For example, buying German Bonds and shorting (selling) UK or Greek Bonds.

Take-aways

  • Negative interest rates are fully compatible with economic theory and represent effective expectations of the economic agents.
  • Regulated financial institutions and Central Banks have to hold bonds, no matter the return, no matter the interest rate
  • Central bank flood the market with cheap money and buy huge amounts of bonds as part of their QE programs
  • Investors may use government bonds as a proxy to bet on currencies, even though the interest rates are slightely negative.

Further readings