It may seem crazy to buy bonds at negative yields, but it does make sense.
The idea of paying to lend someone money may seem crazy, but that is exactly what is happening with some European government bonds.
The most recent example was this morning. At the most recent Swiss government bond auction, investors accepted an average yield of -0.158% for nearly CHF1bn of three-month Swiss government bonds. This means that, for each CHF1,000 bond, investors paid out CHF1,001.58. In return for this, they will receive CHF1,000 back in three months' time.
The reason is simple; they know that their money will be safe and will be returned to them promptly and completely when the bond matures in three months.
This can't be normal
While negative yields are not exactly normal, they are not unprecedented, either. Back in the doom and gloom of January, when an uncontrolled Greek default seemed possible, investors bought £3.2bn of German government bonds with an average yield of -0.0122%.
Swiss government debt provides a perfect safe haven from the risk of stock market turbulence and eurozone defaults. In a stark contrast to the Swiss result, investors buying Spanish government three-month bonds this morning demanded twice the interest they asked for in March -- resulting in an average yield of 0.634%.
Why is this happening?
For most private investors, the idea of buying anything with a negative yield would be plain crazy. After all, if nothing better is on offer, then you might as well leave your money in an FSA-protected cash savings account.
However, it's a different story for institutional investors like pension funds and big companies. They have vast amounts to invest, some of which must remain safe and accessible in the short term.
Leaving it in cash just isn't safe or possible for these investors, so they are willing to pay a small fee -- a negative yield -- to keep it safe.
Negative yields can even be profitable
Although profit isn't the main attraction, it is still possible for investors to make profits from bonds with negative yields, if they are exposed to price deflation. Price deflation does not have to be general: for a corporation, it could apply to specific raw materials that it must buy.
For example, if the price of a certain commodity falls by 1% over six months, then a negative yield of 0.5% over the same period will deliver a 0.5% profit, as the value of the commodity will have fallen 0.5% more than the value of the money used to purchase it.
It would be madness for you or I to buy bonds with negative yields, but there are plenty of good quality, high-yielding opportunities for income investors in corporate bonds, which are much easier for private investors to buy and sell than they used to be.
The fact that big investors have such a strong appetite for safe but poor returns highlights the level of fear in the market. While this might create attractive investment opportunities, it does mean that like the buyers of Swiss government bonds, you should keep your short-term savings well away from the stock market.
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