I know what coupon rate and yield to maturity is but I do not understand very well the interest rate of 0.07% in 1 year Treasury bonds, for example. And how can bonds reach 0 and negative interest rates? why would someone buy it?
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4 Answers
And how can bonds reach 0 and negative interest rates?
0% interest is simple. You just skip the coupon payments and get your money back when the bond matures. Negative interest rate bonds are issued at a higher price than the face value. See investopedia for more info
why would someone buy it?
Any private investor would obviously just keep their money cash in a bank account and be better off. Although negative interest for deposits exceeding 100 000€ is already quite common here in Germany. With negative interest rates up to 1% for some banks, a -0.3% government bond does not sound so bad any more. However, in practice, few people will have the issue of owning too much cash and there is always the alternative of spreading your savings over multiple banks.
It is mainly institutions that are buying negative interest bonds. If you hold 192 billion in cash, spreading it out over multiple banks is no longer an option. If you are a bank yourself, there is also no real alternative. Another important investor buying these bonds are funds that are required to invest a certain amount into bonds. If your asset allocation requires you to have 40% in AAA bonds, there is not much choice
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In Denmark the limit for -0.6% interest is usually about 13000 euro (100000 dkr). Mar 18, 2021 at 19:05
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spreading it out over multiple banks is no longer an option.To back this point up, there appears to be about 4500 FDIC insured banks in the US, so at 250k per bank you would run into problems once you had a little more than a billion dollars.– epsMar 18, 2021 at 21:53 -
@eps don't forget credit unions... 5500 NCUA insured credit unions means you could put off problems until 2 billion (if you could qualify for membership at all of them :| )– FoonMar 18, 2021 at 23:09
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@Foon thanks, now it won't be a problem for 20,000 years instead of the 10,000 I thought it would be.– corsiKaMar 19, 2021 at 6:27
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2@eps And what is the cost of the admin overhead to deal with 4500 banks?– gerritMar 19, 2021 at 10:29
Why would someone buy it?
Think pension funds, mutual funds, etc. They have huge amounts of funds and often a lot of excess liquidity which needs to be placed somewhere relatively secure. They could place them in a bank account, but the risk is then completely down to the risk assessment of the bank; and only a very small fraction is actually covered by the state in case of a bankruptcy of the bank (if any at all, depending where you are located, in EU it is 100,000 EUR, which is a small help if you placed 1 billion).
Second option is to hold the cash in a secure vault somewhere, which for many many practical reasons is not really feasible (and not to mention probably even more expensive than negative interest rates to a certain degree; security guards, alarm systems, building a vault, etc.)
Thirdly, they can invest in super low risk government bonds which some will argue are what you define as risk free, even though they are actually not completely risk free. Even if you need to pay negative interest rates, it is probably the best deal many of these funds/firms can do with their liquidity without putting it too much at risk.
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1As physical cash is such a small percent to digital money supply, why a vault? The majority of money, currency is digital.– pauljMar 18, 2021 at 21:28
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6@paulj digital store of currency is done by depositing the money in a bank, which is exactly the scenario where these negative interest rates are charged. Mar 18, 2021 at 21:37
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@paulj While it's true they could technically look to other means to store their balance digitally none of these are going to be acceptable transfers from their current accounts. You would have to transfer out to cash first and would suffer the same issues as the second option anyway. Mar 19, 2021 at 2:16
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1@paulj If they're going to store it in bitcoin or another cryptocurrency (the only way to store "cash" digitally without a bank?) they still have security storage costs. And de facto, that's an investment anyway, and a highly risky one.– gerritMar 19, 2021 at 10:30
You'll buy it when it is better than the alternatives.
The alternatives include
- A vault full of paper bills.
This is really expensive to maintain. You need a location, transportation, security, insurance.
- A deposit at a bank.
This relies on the bank staying solvent, and whatever interest rate the bank offers. If the bank offers a worse negative rate, that isn't good.
- Investing it in something
Now, companies at this point can borrow money at rates very similar to their risk premium. It takes effort to figure out what the risk premium is on an investment.
And as a insurance company or the like, you aren't allowed to park all of your assets in such investment. You have to hold certain amounts of "zero risk" investments, like AAA bonds or cash. So now you are back to options 1 or 2, and you have too much money government insurance in a bank account...
If you have 100$, buying a negative rate bond is probably a bad idea. And your wallet makes a pretty good storage mechanism.
If you have closer to 100,000$ the pile of cash solution starts looking like a bad idea (the stories of people losing the money they stuffed into a mattress or coffee can are not rare), so hopefully you have something else better to do with your money, like pay off a mortgage or the like.
If you have 10,000,000$, the pile of cash is simply dumb. Maybe there are people you can give your 10,000,000$ to that guarantee they'll return it. How good is that guarantee however? Governments won't give you a guarantee on 10,000,000$ into a bank account, so you are actually betting on the bank's solvency.
If you have 1 billion dollars, you aren't putting that in a deposit account, and any vault with a pile of cash in it is going to look like fort knox (not cheap).
If you have 100 billion dollars, even fort knox isn't secure enough. Any place you put your cash is going to distort the economy and magnify any risk that is there.
Mo money, mo problems.
People would buy it because the price of the bond can go up, while the yield goes even lower and more negative. The higher the price of the bond, the less the buyer makes from the interest, but there are plenty of opportunities to trade the bond itself to somebody else at a profit or loss. There are a lot of outcomes that maintain this trend of yields going lower and this requires bonds having a higher price.
The other reason is that this is intentional. Bonds are going higher in prices because the government doesn't want you to keep its money in its "we'll pay you back slowly over time" program. They want you to think twice and find the yields unattractive, so that you are forced to grow your money in the real economy, by investing in businesses or consuming. If bonds have a negative yield, that means people - like you - are literally saying "I would rather pay the government for the privilege of not investing in these crappy businesses and private equity gambles". The well structured businesses have all been funded already, there are plenty more that could be good businesses but people would rather not find out. So buying government bonds at any price is the only thing left for them.
