Think back to your earlier days in school – and cast your mind specifically to the somewhat laborious task of learning and doing maths. While the mere thought of the subject invokes a distinctly negative reaction for many people, there is nonetheless something important to take away from those lessons. Most people, when introduced to the very basics of financial maths, would have learned about the idea of interest. Interest, we are taught, is what we pay someone in order to borrow money. To think of it in another way: it is the ‘price’ of borrowing. The theory behind what interest really is, is a far more in-depth and esoteric study – but for all intents and purposes, the ‘price of borrowing’ is a good working definition.
With this in mind, imagine a situation in which you are borrowing money from someone for a year. Usually, you would pay back the original amount with a little extra (interest) to compensate them for their service. Now imagine, instead, that at the end of the year, you give the person less than they originally lent you, and they accept! In effect, you are paying a negative interest rate or, put differently, the price of borrowing is negative.
While this may sound like an absurdity, it is characteristic of what is happening in the European sovereign debt markets. The yields (‘interest’) on bonds issued by European governments with high credit ratings – such as France, Germany and Switzerland – have been negative for much of this year, particularly for short- and medium-term bonds. In fact, French government debt has positive yields only for bonds with maturities of 6 years or greater; the corresponding maturities are 7 years for German bonds, and 15 for Swiss bonds. To give a better idea about what this all means, consider the following: at current yields, the purchase of a new 5-year Swiss government bond means that for every 100 units of currency invested, the lender would only have 95.21 upon maturity.
The absurdity does not stop there, however. Even Portugal – bailed-out just a few years ago – has enjoyed negative yields on its 6-month government bonds this year. In fact, despite Portuguese debt not being rated as ‘investment grade’, auctions for short-term bonds have been significantly oversubscribed. Naturally, this situation warrants an explanation.
The first adventure into negative-yield territory took place during 2011. At the time, the major concern in Europe was the solvency of some of the European governments – the so-called PIIGS nations. The solvency of commercial and investment banks was also brought into question, and investors had doubts about their ability to withdraw their deposits or investments if needed. As a result of all the uncertainty, investors flocked to ‘safer’ assets such as short-term, highly-rated government bonds, and gold. In fact, the increased demand for gold at the time caused it to reach its all-time high of over $1900 per ounce. With regards to the negative yields on government debt, financial journalists aptly pointed out investors’ preference for a return of capital, rather than a return on capital.
The picture today is somewhat different. The solvency concerns are not at the forefront now as they were in 2011. Earlier this year, asset manager PIMCO cited a few reasons for why European debt is again exhibiting negative yields. The first has to do with intervention by the European Central Bank (ECB): monetary policy conducted by the ECB involves large purchases of government bonds, which drive the prices up, and the yields down. Investors anticipating ECB purchases could buy up bonds at negative yields and still sell them profitably in this instance.
Another two reasons are related to macroeconomic conditions in Europe. One possibility is that investors are preparing for an economic downturn – in which case marginal losses on bond investments would essentially be the ‘insurance premiums’ paid to avoid the potentially larger losses that would be incurred if assets were held in other investment classes. The other possibility is price deflation, in which case a nominal loss on bond investments could still be profitable in real terms, provided that prices fall sufficiently.
Looking to the future, one of the interesting consequences of these low bond yields pertains to pension funds; these are some of the largest institutional investors in the bond markets. As some assets reach maturity and new bonds are purchased to replace them, the lower returns on assets means that European pensioners may in future receive lower benefits than expected, or that those working and contributing to pension funds may be asked to pay more. In either case, the nature of the European social democracies would suggest that even more government meddling might be enacted to cover the shortfall. European governments may be enjoying cheap borrowing today, but it could certainly cost them dearly in the long run.
It should be stressed that in both 2011 and the present, the events and concerns leading to these strange bond market phenomena have been caused by European governments – either through the actions of the ECB, or through government interventions and regulations in the economy which make the financial sector more unstable, and the broader economy weaker overall. It is nonetheless interesting that the bubble in credit-based securities has not been eliminated since the recession, so much as shape-shifted from being a private-sector debt bubble, to a public-sector one. It is remarkable how government actions can take an otherwise sane and (mostly) rational market, and turn it on its head. For the past century, this has been a recurring theme in the financial markets, but as will be shown in the next article, the folly of negative prices is not unique to that sector.