(PUB) Investing 2016

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The Strange Mechanics of Negative Bond Yields Income Strategist | Eric Jacobson

to purchase that bond when market yields are at zero, the price would actually rise all the way to $1 , 100 . The investor would have to pay an extra $100 in order to make the transaction worthwhile to whomever is selling it, because the seller is giving up claim to the bond’s future coupon payments. The math is a little trickier once you get to a negative yield. In that case, if yields were to fall all the way to negative 1% in the marketplace, its coupons would become even more valuable to investors, and our hypothetical 10 -year Treasury with a 1% coupon would actually command a large premium— $211 in this example. How Does This Even Happen? There are several reasons why an investor would buy a bond with a negative yield. They might do it because they fear a recession accompanied by deflation. In such cases, large investors might buy “safe” assets that charge a premium for that safety. In today’s environment, though, central bank activity is the primary driver of negative yields. Against the backdrop of sluggish economic growth and low infla- tion, one of the first levers central banks turn to is to charge for commercial banks to deposit money with them overnight. That has the effect of pushing down short-term interest rates, and the impact typically ripples out to longer maturities depending on the market’s reaction. Central banks also contribute to negative yields through quantitative easing as they buy large enough quan- tities of long-term bonds to dramatically reduce the supply and market yields of these bonds. Negative yields are unlikely in the U.S. The Federal Reserve chose to leave short-term rates unchanged in September but left the door wide open for a boost later this year. Most investors should be reason- ably content to see them go up as long as improving economic conditions are the cause. K Contact Eric Jacobson at eric.jacobson@morningstar.com

Although we haven’t yet faced the problem in the United States, negative bond yields have made head- lines for much of 2016 . But what exactly does it mean for bonds to offer negative yields and why would investors be willing to invest in them? Follow the Math Although bond math is messy, it’s easy enough to understand that if you buy a plain-vanilla bond for $1 , 000 and it pays 10% per year (if only…), and you get your $1 , 000 back at maturity, you’ve made some money on the deal. To understand negative yields, though, it’s important to remember that there’s a big difference between the coupon rate of a bond expressed as either a dollar amount or percentage and its yield to maturity. The former is a simple expression of the payments a bond makes periodically, relative to its face value. On its own, it doesn’t tell you anything about a bond’s overall return. A bond’s yield to maturity is meant to provide a snapshot of its expected annualized total return, though taking into account how much an investor pays for the bond, how much income it produces, and how much the investor gets back at the end. Whether you pay more or less than a bond’s face value up front will have a very important impact on what your ulti- mate yield to maturity, and thus your ultimate return, will be. Consider the simple example of a Treasury bond with a 1% coupon that matures in 10 years. If the market rate for that bond is a 1% yield to maturity, its price should be $1 , 000 (the standard denomination for a plain-vanilla Treasury.) What would happen to the price of the same bond if market yields were to go to zero? Remember, it’s the same bond, so it’s still paying the same coupons and will still return $1 , 000 at maturity. All other things equal, the value of those coupon payments to an investor would go up. In fact, if an investor were