Why Investors Want to Invest in the Bonds Even When They Have Negative Yields - Essay Example

Running header: Bonds Student’s name: Instructor’s name: Subject code: Date of submission Introduction Traditionally, it has been thought that investors would invest in bonds since they are guaranteed of a positive return from their investments. However, it has been deemed abnormal that interest rates on a range of debt mostly government bonds from such countries as Germany and Denmark and corporate bonds from such companies as Nestle have been selling at negative yields. The most surprising thing is that we still have people buying the bonds even at negative rates. This paper looks at the issue of bonds with negative yields and the reasons why investors would still invest in them. Bonds as financial instruments and their functions Bonds are a form of debt securities that are similar to IOU usually issued by corporates and governments. They are issued as instruments of indebtedness by their issuers to the holders as a confirmation that the issuer owes the holder adebt and that the issuer is obligated to pay theholders interest stated on the coupon as well as the principal at the maturity date. The interest on bonds is paid on fixed time intervals usually annually or semiannually but sometimes it is also paid monthly but very rarely. As such, bonds are termed as a form of external source of financing for usually for long-term investments (Fidelity investments, 2015). The government also uses bonds in seeking funds to finance current expenditure. As such, bonds are similar to stocks with their difference being that stockholders own equity stake in the organization while bond holders have a creditor stake in the firm. Bond holders are thus given priority in the payment of interest and are also paid before stockholders in case of winding up. They also differ from stock in that they have fixed maturity date after which they are redeemed while stocks are held indefinitely. As external source of finance, bonds have a number of characteristics including the fact that they have set maturity dates which may be short term or long-term as stated above. Bonds also offer some form of interest depending on their structure with fixed rate bonds providing fixed interest at regular intervals. On the other hand, those with floating rates have variable interest rates. Bonds also have principal interest repayment feature in that the issuers have the obligation to pay the principal when they reach maturity. Some bond rating agencies also issue credit ratings for bonds with which borrowers can evaluate their credit risk. Callable bonds can however be redeemed before their maturity date by the borrower paying the loan to stop paying interest. Bonds also have minimum investment with most ranging from $1,000 to $5,000. Bonds have a lot of advantages which is why many investors choose to invest in them. For instance, Bonds are a reliable source of current income especially when they have to pay fixed income regularly (Jared, 2010). They provide a certain element of liquidity since the market is active and large. When one sells a bond before its maturity, one receives more than the principle due to value fluctuation. In many instances, interest income arising from bonds is tax exempt especially if they are government bonds. In addition, they are regarded as low risk level investments. Investors can invest from various types of bonds that are available in the market. These include corporate bonds which include money borrowed by corporations, municipal and government bonds which are money borrowed by the state or local governments. The buyers of the bonds There are numerous buyers of bods ranging from individuals, corporate and government agencies. Government agency trust is an example of government agency that invests some of its money in bonds. Such an agency usually has more income than is currently needed. Rather than keep the monies in their accounts, they opt to buy bonds that are considered to earn higher interests. Other retirement funds in the country also invest in bonds. On the other hand, the public individuals with excess money also find investment in bonds a suitable investment given that it is a source of income while the principal is secure since it will be repaid on maturity. Banks are other institutions that buy bonds. Many times, banks have excess cash that they may not need in the short run. Since most bonds earn higher interests than would be given by the central bank, they opt to invest in bonds. In some cases, the central banks charge a little interest for holding reserves for banks in excess of the statutory minimum (The economist, 2015). In such a case, banks would prefer to invest in bonds since they will earn interest. Insurance companies and investment companies are also buyers of bonds. Insurance companies have to diversify the risk on the money paid by the insured as premiums. One way of doing this is through buying bonds. Similarly, one of the ways that investment companies invest their clients’ money is by buying bonds. Private pension funds are also vital players in the bond market. They invest some of the pensioner’scontributions in form of bonds and shares. This way, they are assured that the money will earn interest for thepensioners. Other corporates may also find it important to invest in other companies bonds especially when they have excess resources whose immediate use has not been identified. In other words, the players in the bond market or the buyers of bonds are diverse and they range from ordinary individuals, small and big companies, government agencies and even multinational companies. What factors might prompt buyers of bonds to buy bonds with negative yields Many countries have had their bond yields plunge below zero hence turning the investment world on its head especially for those who have invested millions of dollars. Having to pay for investing or lending someone money be it a government or corporates does not seem to make economic sense. However, some investors have still found good reasons to invest in these negative yielding bonds. Among the reasons that would make one want to invest in a negative yielding bond are explained below. Investors expecting or fearing deflation would find nominal bonds even with negative yields to be attractive provided the expected yield will make the real yield of the bonds positive. During deflationary periods, investors will always shift away from investing in real assets to investing in nominal assets (Mathew, 2015). This was evidenced in Japan in the previous decades when investors shifted from buying equities and investing in real estate to government bonds and keeping their savings in cash. On the other hand, if investors are speculating on currency appreciation, they might opt to buy the bond even if it has a negative yield since it is hoped that after the appreciation, they might gain and hence making a profit on the negative yielding bond. For instance, investors bought Swiss government bonds when they expected the local currency to appreciate after the government stopped pegging it on the Euro. Investors will buy a bond with negative yield when they expect to gain from central bank easing. For example, investors who have bought euro area bond over the last couple of months anticipating that the European Central Bank would cut rates as well as its quantitative easing program have been realizing strong capital gains already (Brown, 2015). In addition, some of these investors would continue holding on to their investments in bonds despite their having negative yields since they anticipate that they will make capital gains in future as conditions improve. Another good example can be seen in investors who have been buying Swedishbonds asthey speculate on the country’s central bank to cut its repo rate to further negative regions in the future. The central bank of a country could also buy bonds with negative yields. For example, the European Central Bank indicated that its quantitative easing program would also see it buy nominal bonds with negative yields (Investinginbonds.com, 2015). The bank funds the purchase of bonds at a depo rate of 20bp and hence the bank’s purchase of bonds with a slight negative yield will still be a positive carry trade. In addition, the bank of Japan has been buying government debt securities at a negative yield rate recently. Passive funds or indexed funds also buy bonds that have negative yields. The world has been growing thanks to an increased shift towards passive investments. There has been increasing shift towards passive investment in bonds with the current passive investment in bonds estimated to exceed $900 billion globally. It is worth noting that only a small portion of this passive bond funds has been invested in government bonds though it is significant. In addition, banks also buy bonds that have negative yields in a bid to escape negative depo rates such as the ones by the European Central Bank, SNB and Danish central bank (John, 2015). It is worth noting that currently there are reserves worth $220 billion subjected to negative interest rates and the amount is increasing since the introduction of quantitative easing by the ECB. As such, banks find it prudent to get rid of the above reserves through purchasing of bonds with yields as low as -75bp in a bid to reduce loss owing to the negative depo rates they are subjected to by the central banks after exceeding a certain minimum of reserves. In buying bonds with a negative yield, the investor would have made safety considerations. This is because bonds are backed by the full faith and credit of the government issuing it. This is as opposed to bank accounts that are only government guaranteed up to a certain amount with most European countries covering 100,000 euros only. As such, big companies and super rich individuals have to find a better way of securing their money and hence opt to opt in bonds though they have a negative yield owing to their relatively low risks. Whether there is a case in economic theory for buying bonds with negative yields One explanation for bonds having negative yields is the law of supply and demand. Since there is too much demand for the bonds, this is causing their price and hence interest to fall to negative levels. On the other hand, when the demand for the bonds fall, the interest rates and hence price has to fall. In this regard, it is hoped that investors invest in bonds with negative interest in the hope that such interest will rise in the future as their demand fall. It is also hoped that after economic conditions improve, people would be willing to invest in more risky areas thus lowering the demand for bonds thus bringing up the interest rates and hence the investors would make a capital gain. Other reasons why investors would buy bonds with negative yieldsis if they are risk averse (Shaffer, 2015). This would serve as an insurance premium for keeping their money in a soft and liquid debt instrument as opposed to investing in banks which are much more risky. Another economic explanation is that in a deflationary environment, the real inflation adjusted return on a bond with negative yield will actually be positive depending on the level of inflation. For instance, a bond yielding negative 1 percent will be positive if the consumerbuying power reduces by 2 percent. If the bonds yield fall further to the negative areas, the investors would still make a capital gain since the bond’s price would move in the opposite direction thus rising. Speculations that the currency in which the bond is sold will improve would still cause the investor to buy the bond even if the yield is negative since he/she expects to make a capital gain out of the appreciation. Other reasons include the statutory requirements of some organizations to keep part of their capital in bonds. Conclusion Although investors would normally want to only invest in bonds that have positive yields, it has been discovered that there are reasons that would still make investors want to invest in the bonds even when they have negative yields. These reasons have been explained above. They would include speculation, regulatory requirements among other reasons. References Fidelity investments, 2015, Individual bonds, Retrieved on 13th April 2015, from; https://www.fidelity.com/fixed-income-bonds/individual-bonds/overview Jared, P2010, Introduction to public finance, London, Rutledge. The economist, 2015, Accentuate the negative: Why investors would opt to lose money, Retrieved on 13th April 2015, from; http://www.economist.com/news/finance-and-economics/21640373-why-investors-would-opt-lose-money-accentuate-negative Mathew, Y2015, Something economists thought was impossible is happening in Europe, Retrieved on 13th April 2015, from; http://www.vox.com/2015/2/5/7981461/negative-interest-rates-europe Investinginbonds.com, 2015, How big is the market and who buys? Retrieved on 13th April 2015, from; http://www.investinginbonds.com/learnmore.asp?catid=5&subcatid=18&id=174 John, H2015, Who would buy a bond with a negative yield?Retrieved on 13th April 2013, from; http://www.theglobeandmail.com/globe-investor/investor-education/who-would-buy-a- bond-with-a-negative-yield/article23132250/ Shaffer, L2015, Negative yield bonds: Here’s who is buying, Retrieved on 13th March 2015, from; http://www.cnbc.com/id/102391008 Brown, J2015, why buying bonds with negative yield isn’t as weird as it sounds, Retrieved on 13th April, 2015, from; https://www.mainstreet.com/article/why-buying-bonds-with-negative-yield-isnt-as-weird- as-it-sounds Read More