Bonds are safe investments, there is little risk of losing your capital and in time of high volatility investors will move into bonds to reduce loss of capital even though they know that they will give up the possibility of growth and in some cases will even accept that they will have a negative return, hence Negative Yield Bonds.
Buts fist let’s look at what a bond is, basically as bond is a promise to pay you back the original investment plus interest over a time period. A bond has two yields:
1. Current yield – this is the amount you will receive each year or the coupon rate.
2. Yield to Maturity – this takes into account the income received and any gain or loss basedion buying the bond either under face value or above face value.
You invest $10,000 in a 2 year bond at an interest rate of 2% (Current Yield); over the term of the bond you receive $200 per year interest, total $400. At expiry you get back your face value being $10,000.
All is good with the investment.
The Bonds market value (the amount it can be sold for before maturity) however will change when interest rates change, for example if you invest as per the above example, but interest rates move up to say 4% during the 2 year time frame then the market value of your bond will reduce to $5,000.
Why? Because if you want to exit the bond before the maturity and potential buyers can receive a 4% yield elsewhere so you will need to reduce your price to sell. This is when the yield to maturity will change. In the above example after a year you would have received $200 interest and $500 back in capital. Your yield to maturity would be negative $300 or -30%.
In time of extreme uncertainty investors can go knowingly into bonds which will lose them money. A good example is the Brexit, which just happened. Investors were so keen to move into safety they are prepared to pay more than the face value of the bond.
So if we take our above example investors may pay $10,500 for the same bond. They will still receive the 2% return each year but only on the face value of $10,000.
So after holding the bond for 2 years they would receive $400 in interest and $10,000 back for the face value total $10,400. Therefore losing $100 incurring a loss of 9.5% for the period.
Why would someone invest in something which they knew would lose them money?
There are three main reasons:
1. Large managed funds have a mandate that a proportion of their fund must be invested in bonds. When volatility is high causing negative yields they have no choice but to invest the funds.
2. Investors are concerned about exchange rate risk, as such instead of holding cash in their currency may look to hold an international bond.
3. Investors are so irrational that they feel that this is the best way to protect their money and accept the loss assuming it will be less than if they maintained their current investments.
Bonds are not without risk, as such all investors need to look carefully into what it is they are investing in and ensure that the Yield to Maturity is positive and not just focus on the current yield.
It might surprise you to know that in Germany around 40% of bonds on offer have negative yields.