For the first time in recorded history, many European countries, plus Japan, have experienced negative interest rates. Government bond yields on short-term debt, as well as debt up to 10-year maturity, have turned negative in many countries, including Austria, Denmark, France, Germany, Finland, Switzerland, Sweden and Japan. More than 25 percent of European sovereign bonds sell with negative yields.

Those governments can sell debt and get paid by investors for doing so. For investors, buying a bond with a negative yield means they won’t get all of their money back.

There have been many periods where real rates of return (inflation-adjusted) have been negative, but this is the first time nominal rates have turned negative. For example, if $100 is lent for one year with interest of 4 percent payable at the end of the year plus principal, the nominal yield or return, assuming annual compounding would be 4 percent. If inflation was 2 percent during the year, the real yield or return would be approximately 2 percent. If inflation exceeded 4 percent, the real yield would be negative.

This has occurred many times and in many locations throughout the world when inflation rose higher than expected. In fact, this happened in the U.S. in the late 1940s, 1970s, and recently in the 2000s. Bond yields reflect inflationary expectations, so unexpected or unanticipated inflation hurts bond investors as required yields go up and bond prices down.

What happens if an investor is willing to pay $105.50 for the same bond that pays $4 in interest plus $100 of principal back at the end of the year? The investor is guaranteed a $1.50 loss and a nominal yield of -1 percent. If annual inflation was 2 percent, the real yield would be -3 percent. Why would investors pay $1.50 to lend or invest $100? Has the world turned upside down or have investors just gone nuts?

Investors would not usually lend or invest money at negative nominal yields if inflationary expectations were positive. But if deflation was expected, investors could still earn a positive real return.

It appears that investors are more worried about “return of capital” than “return on capital” and are willing to accept negative interest rates.

In the above example, if deflation was 2 percent for the year, the real return to the investor would be +1 percent. Deflation is good for bond investors because they are paid back in a more valuable currency that will have more purchasing power. If it is good for bond investors, deflation is bad for borrowers as they pay back interest and principal in a more valuable currency. Deflation usually occurs when economies are not doing well, so it can be a double whammy for borrowers.

Deflationary pressures have plagued Japan for nearly two decades, and Europe and the U.S. more recently. If not outright deflation, most countries have experienced disinflation, the slowing down of the rate of inflation.

The consumer price index (CPI), sometimes called the cost-of-living index, on a monthly basis measures the cost of a fixed basket of goods and services purchased and used by a typical consumer. Generally, because of their volatility, food and energy are stripped out of the headline inflation number, which includes all goods and services; what is left is called core inflation. The difference between headline and core inflation numbers can be significant.

In the U.S. for the 12 months ending in February, the headline inflation rate was zero, while the core inflation was 1.7 percent. For the 12 months ending in January 2015, the headline inflation rate was -0.1 percent. The Eurozone and other European countries have experienced deflation in both the headline and core measures. This has prompted most major central banks to target an inflation rate of 2 percent, although this target has not been met for several years now.

Low inflation, deflation and deflationary expectations have been mostly responsible for the negative bond yields. Central banks have also played a major role, especially their impact on short-term interest rates. One consequence of the financial crisis and Great Recession is that central banks have loaded banks with excess reserves, those not needed to support loans and deposits.

If banks do not make loans or invest, the excess reserves build up at the central banks. In the U.S., for example, excess reserves have increased from $20 billion in 2007 to $2.6 trillion today. The Fed pays banks 0.25 percent annually on excess reserves, but the European Central Bank (ECB) charges banks -0.2 percent as an incentive for banks to lend or invest excess reserves. This negative 0.2 percent has put downward pressure on short-term interest rates here and in Europe.

A new regulatory environment has also impacted interest rates. In the U.S., banks must pay an insurance premium to the Federal Deposit Insurance Corp. The Dodd Frank Act requires insurance on nearly all deposits even though only those up to $250,000 are insured. The net result: insurance premiums cost banks 0.2 percent annually on each dollar deposit and can be as high as 0.45 percent for a large bank with large deposits.

In The Spotlight

J.P. Morgan recently announced that they will charge up to 5.5 percent on certain deposits — meaning customers pay 5.5 percent annually for the privilege of depositing money at the bank, a negative interest rate for sure. J.P. Morgan and other big banks are obviously trying to eliminate high-cost deposits by charging fees for large deposits. This has further reinforced low and negative short-term interest rates.

Another regulatory factor is the new liquidity rules that banks in the United States and Europe must cope with. As such, banks must hold high-quality liquid assets equal in amount to the deposits that may run or be withdrawn in times of stress. To meet this requirement, banks are investing in U.S. Treasuries and other sovereign bonds with zero risk of default. U.S. banks, for example, own $2 trillion of U.S. Treasury bonds. European banks are doing the same.

Add in the amount of sovereign bonds the central banks own or will own and there is a shortage of high-quality sovereign bonds available for other investors, putting downward pressure on interest rates. The U.S. has experienced negative interest rates on overnight borrowing using U.S. Treasury securities as collateral because of their scarcity. The ECB quantitative easing (QE) program that just started in Europe plans to purchase $1.2 trillion of European sovereign bonds over the next 18 months. Many question whether this is even possible, but it surely will be a drag on European interest rates.

European interest rates are lower than the U.S. because of a weaker Eurozone economy and the start of its QE program. This is true for the corporate sector as well where European bond yields are 1.5 percent less than equivalent U.S. yields. Nestle was the first corporation to have a negative yield on its debt, prompting a new slogan, “In Nestle We Trust.” Many U.S. corporations are rushing to Europe to issue new debt in euros to take advantage of these low rates. There may be more corporate debt with negative yields in the future.

Buying a bond with a negative yield does not necessarily mean investors expect a loss. Foreign investors may buy a negative yielding bond if they think the currency the bond is denominated in will appreciate, making money on the currency change, not the interest yield. The Swiss franc has been unpegged from the euro and has appreciated considerably, which is why the yield on the 10-year Swiss government bond has been negative as well as Nestle’s.

The strong dollar has made investing in the U.S. more attractive and has put downward pressure on U.S. interest rates. While it guarantees a loss if a bond is held to maturity, some investors may assume interest rates will be even more negative before the bond matures enabling them to sell at higher prices prior to maturity.

It appears that investors are more worried about “return of capital” than “return on capital” and are willing to accept negative interest rates. Given the flight to quality, investors are willing to lose a little to make sure they don’t lose a lot.

Is the bizarre world of negative interest rates coming to the U.S? Probably not as the Federal Reserve contemplates raising short-term interest rates in 2015. There is a big divergence in global monetary policies as the U.S. tightens and Europe and Japan maintain loose monetary policies.

The U.S. economy is doing better than Europe and Japan, so higher relative interest rates are justified. But they may not move significantly from the historically low rates that exist today. Great for borrowers but repressive for savers. Nevertheless, it is strange and unprecedented historically to pay someone to borrow money from you.


Robert Klemkosky
About The Author Robert Klemkosky
Robert C. Klemkosky is professor emeritus of finance at Indiana University Kelley School of Business. He was the founding dean of SKK Graduate School of Business at Sungkyunkwan University in Seoul, a top MBA program in Asia, and currently is chief investment strategist at Wallington Asset Management, an Indianapolis-based money management firm.

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