In this blog, we will be covering the meaning of bonds, negative bond yield and how it works in investing.
To understand all of this, let us first understand the meaning of Bonds -
What are Bonds?
Bonds refer to debt instruments that are issued by companies or governments (bond issuers) to raise money. These bonds are purchased by investors at face value and in return, they get paid a coupon rate, i.e., the interest for investing in the bonds. Bond issuers borrow money for a certain period with a commitment to repay the investors. On completion of the maturity period, the investors get the face value of the bond or principal amount invested.
When investors buy bonds, they become lenders to the companies or government. Thus, bonds act as fixed-income investment avenues that provide investors with a secure return.
What is a Negative Yield Bond?
A negative yield bond is when an investor who has purchased the bond receives less money at the bond’s maturity period than the original price paid for the bond.
It must be noted that a bond’s price is inversely proportional to its yield or interest rate, i.e., the higher the price of a bond, the lower the yield. Bonds traded in the open market may have a negative bond yield if the price of the bond trades at a premium price. Investors may sell their bonds if they expect a fall in interest rates and choose to invest in higher-rate bonds later.
What are the reasons for buying negative yield bonds?
Safe Haven Assets
An important aspect that investors consider while investing in bonds that are sold at a negative rate is that they are a safer form of investments. It means that if the negative yield’s bond loss is comparatively less than that of other investment instruments like equity, commodity, ETF or debt, investing in negative yield bonds is still a prudent choice.
Maintaining Asset Allocation Balance
Hedge funds and mutual fund managers are mandated to meet certain requirements like asset allocation. Asset allocation essentially means that investments within the fund must include bonds as a part of their portfolio for diversifying the asset mix. This allocation is necessary because allocating a portion of the portfolio to bonds can reduce or hedge the risk of loss from other investments like equity and debt in the portfolio.
Consequently, hedge funds and investment firms buy bonds even if the bond yield is negative. Also, bonds are used as collateral for financing and thus, they are a part of the portfolio, irrespective of their price or yield.
Deflation Risk and Currency Risk
Some investors opine that they can achieve favourable returns despite facing negative yields. As per them, a rise in the currency exchange rate can offset the negative bond yield. To elaborate, when purchasing government bonds, investors convert their money into the currency of the specific country they are investing in. Conversely, when selling those bonds, they convert the proceeds back into their local currency.
In the case of domestic bonds, investors are willing to accept low-interest rates or prices in the economy, as this approach enables them to optimize the utilization of their savings instead of saving in cash.
Example of a Negative Bond Yield
Let us assume that a Bond ABC has the following financial attributes:
- Maturity Date – 5 years
- Face Value - Rs. 500
- Coupon Interest Rate - 3%
- Bond Price - Rs. 520
Bond ABC was purchased for a premium, meaning the price of Rs. 520 was higher than its face value of Rs. 500 to be paid at maturity. Initially, this might seem negative for the investor. However, the bond's coupon rate of 3% per year or Rs. 15 (3% of Rs. 500) provides an additional benefit to the investor.
Even though the investor paid an extra Rs. 20 for the bond initially, the Rs. 75 in coupon payments (Rs. 15 per year for five years) result in a net profit of Rs. 55 or a positive yield.
Another example is Bond XYZ has the following financial attributes:
- Maturity Date – 5 years
- Face value - Rs. 500
- Coupon Interest Rate - 0.5%
- Bond price - Rs. 510
Bond XYZ was also purchased for a premium, meaning the price of Rs. 510 was higher than its face value of Rs. 500 to be paid at maturity. However, the bond's coupon rate of 0.5% per year makes the bond negative-yielding. In other words, if investors hold the bond until maturity, they'll lose Rs. 10 (Rs. 510 – Rs. 500).
Bonds that are sold at a negative rate are a wise investment choice if one understands the wealth creation journey in detail. To learn more about bonds, bond yield, negative yield bonds, and other avenues of investment, connect with mastertrust today.