Why should you Buy Government Bonds with Negative Yields?

A question worth asking considering the rather large amount of them knocking about at the moment. According to JPM, the total universe of government bonds traded with a negative yield was $3.6tr last week or 16 per cent of the JPM Global Government Bond Index. It’s an answer in itself, really. Anyway, here’s a list of those willing/ forced to buy those negative yielding government bonds:

• 1) Investors who fear or expect deflation tend to find nominal bonds with even negative yields attractive as long as expected deflation makes real yields positive. In a deflationary environment investors tend to shift away from real into nominal assets. During the previous two decades in Japan, this took the form of a shift away from equities and real estate into cash and nominal JGBs.

• 2) Investors who speculate on currency appreciation, for example investors buying Swiss or Danish government bonds to speculate on CHF or DKK currency appreciation.

• 3) Investors who expect capital gains from central bank easing i.e. rate cuts or QE. For example, investors who have been buying euro area bonds over the past six months in anticipation of ECB rate cuts and QE, have seen strong capital gains already and some of them hold on to their investments despite negative yields as they expect further capital gains. Another example is investors buying Swedish bonds currently to speculate on Riksbank cutting its repo rate to negative over the coming months.

• 4) Central banks can buy bonds with negative yields. For example, the ECB stated that its QE program will encompass purchases of nominal bonds with negative yields. The ECB funds its bond purchases at a depo rate of -20bp so buying bonds with slightly negative yields is still a positive carry trade. The BoJ bought government debt securities at negative yields in recent months.

• 5) Indexed or passive funds have to buy bonds with negative yields. This universe is considerable and has been growing due to an increasing shift towards passive investing. In the US the universe of bond and hybrid mutual funds that are passive is $375bn or 7.8% of all bond and hybrid mutual funds. Extrapolating this to the global bond and hybrid mutual fund universe of $11.5tr implies a passive bond and hybrid mutual fund universe of $900bn. And this excludes bond ETFs, a $350bn universe globally. Admittedly only a portion of these passive bond funds invest in government bonds only, but this portion is significant. In the case of bond ETFs for example we note that $150bn out of $350bn of bond ETFs invest in government bonds only.

• 6) Banks buy bonds with negative yields to escape negative depo rates such as those by the ECB, SNB and the Danish central bank. There is currently a large amount of €220bn of reserves subjected to negative interest rates and this amount looks set to grow exponentially due to ECB’s QE (this €220bn includes the ECB’s excess reserves, Danish central bank’s certificates of deposits and Swiss sight deposits subjected to a negative depo rate). And the recent experience in Switzerland shows that even a small amount of reserves subjected to negative interest rates can have a big impact on bond yields. For example, there are CHF380bn of sight deposits at the SNB’s balance sheet but only a small portion of around 10%-15% is subjected to the punitive -75bp depo rate. This is because this charge is only levied above a threshold which is 20 times the minimum reserve requirement. Most Swiss banks including the two biggest are said to be below this threshold. But foreign banks are more likely to be subjected to the negative depo rate. This is also true for financial institutions that do not have minimum reserve requirements, such as insurance companies. These domestic financial institutions are subjected to a fixed threshold of only CHF10m, above which the negative depo rate will be applied. As of the end of December, foreign banks had CHF17bn of sight deposits with the SNB while non-bank domestic institutions had CHF33bn of deposits. At a depo rate of -75bp these CHF50bn of sight deposits could cost CHF375m per annum to their owners. This is enough for these institutions to rush to get rid of these deposits by purchasing bonds with yields as low as -75bp in order to reduce this loss. Most likely they purchase these bonds from banks not subjected to negative depo rate. As a result, 7-year Swiss government bond yields declined to as low as -67bp last week.

Take your pick and remember, particularly where reason number 6 is concerned, things can most probably go lower.