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(1/n) Many find it hard to understand why a logical investor would ever choose to buy a negative yield bond...I am going to try to explain:
(2/n) Most non-bond professionals think about bonds too simplistically, only considering the yield. The reality is that bonds are best thought of as a swap of one yield for another (short-term cash yield for the bond yield)
(3/n) Think about making the decision to buy a 1yr treasury. What factors should an investor consider? One is obviously the yield of the treasury, 0.12% currently, but another is the opportunity cost of foregoing simply holding cash and earning the cash rate of return.
(4/n) For retail investors, the interest rate available on cash is varied. Certain online checking accounts now yield as much as 0.5% whereas others yield 0%. For large players, the return on cash is more standardized, and is approximated by the return on money market funds.
(5/n) The interest on mm funds in turn is highly dependent on the fed funds rate, which is 100% in the control of the Fed. So if you are a large player earning Fed funds on cash, what you are really deciding when you decide to purchase a treasury, is whether you think earning...
(6/n) ...the daily interest rate on Fed funds will be better or worse than locking your money up for two years at 0.12%...
(7/n) The current Fed funds rate is 0.08%, so you are actually doing a bit better owning the 2yr locally, but if the fed hikes interest rates you will be stuck holding the bag earning only 0.12%. (Or conversely if they cut you will feel good.)
(8/n) This all becomes more explicit when we think about levered players like HFs. When a HF goes levered long a bond, either by using futures or “repo”, they will explicitly earn the yield of the bond and pay a rate to borrow cash to buy the bond. This rate is called “GC”.
(8/n) GC is closely tied to Fed funds. If a HF player goes short tsy bonds, they must pay the yield on the bond but they earn the cash rate (GC). Now let’s tie this back to negative yields.
(9/n) Suppose the Fed (or ECB in the case of the Euro) sets the cash rate (GC) at -1.00%. Suppose further that an investor believes they will maintain this rate for the next two years. Now suppose the yield on 2yr treasuries is -0.5%.
(10/n) The investor can do very well by buying this negative yielding bond. Over the 2yrs, if the investor’s Fed view is correct, the will earn 1% for borrowing money to buy the bond at GC and pay out 0.5% for the negative yield of the bond they own.
(11/11) To summarize, bond yields represent the market expectation for the average cash yield over the life of the bond in question. If a central bank is expected to hold the cash rate negative, than the bond yield should also be negative.
