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Assume a simplified world where rates are 0 %, and bonds only carry rate risk (no spread risk, etc).

Let's say I invest in a 10-year bond.

After 1 year has gone by,

  1. if rates have gone up, I've realized negative return, as apart from earning 0 %, my bond's price will fall.
  2. if rates have stayed the same, I get my 0 %.
  3. if rates have gone down, I get positive return (0 % + some gain on the price).

However, rates are zero, so I assume case 3. will never happen, since rates typically do not cross zero.

So my question is, following the above logic, is it sound to conclude that if rates are zero, bond's can never give a positive return but only a negative, and best case is 0 %?

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  • In Europe, out of the last 10 years, 8 years had negative rates. Positive rates currently feel as if they are the atypical ones.
    – Solarflare
    Commented Feb 5 at 22:17

2 Answers 2

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When we say that "rates" are zero, we are referring specifically to short-term risk-free rates. Other rates can and generally will be higher. If you are buying bonds for an organization with default risk, the actual rate might be higher. If you are buying long-dated bonds, the actual rate will definitely be higher, even if you are buying government bonds (e.g., compare "the" interest rate to the actual rates paid on, say, 30-year Treasuries).

Regarding your concern that when rates are low, there is no upside to bonds, that is part of the reason for the premium on long-term bonds. Short-term bonds don't carry much interest rate risk, so you don't get much of a premium over "the" rate to hold them, but long-term bonds do, so you do. Borrowers are willing to pay that premium if they think that rates will go up in the future because the long term locks them into lower rates (and pushes the need for refinancing further down the road).

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Bond rates can go negative (Japan has had negative rates for years trying to encourage people to spend or invest rather than save) but yes barring those extraordinary circumstances, a "zero" yield would be the floor for nominal return.

You could, however, still get real return if the the purchasing power of those funds rose due to deflation, but it would the the equivalent of sticking cash in a mattress.

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