Astonishingly, almost a quarter of all debt issued by governments and companies around the world now trades with a "negative yield".
In other words, these bonds offer a return of less than zero – or a loss.
Bond yields and bond prices move in opposite directions: when prices rise, yields (the regular interest paid relative to the price) fall. Negative yields occur where bonds are trading at such high prices that investors who buy and hold them to maturity are guaranteed to experience a negative return – taking into account interest payments and the return of capital.
This gives rise to a number of questions. How has this peculiar situation come about, and should we expect it to persist? Most importantly, why would anyone make an investment which – if held to maturity – is guaranteed to lose money?
Explaining negative yields
Over the past decade central banks around the world have taken unprecedented measures to stimulate economic growth, including dramatically cutting interest rates. The latest rate cut from the Federal Reserve was the 729th since the financial crisis.
In some cases, in order to encourage other banks to lend money, certain central banks – including the European Central Bank and the Bank of Japan – now impose negative interest rates on deposits placed with them. This drives down bond yields, which tend to be viewed in relation to the interest rate available on deposits. If, for example, a central bank sets a base rate of minus 0.5%, a yield of zero on a bond could look attractive.
Over the past few months, a weakening economic outlook and persistently low inflation has led investors to expect very low or negative policy rates far into the future.
As a result, government bonds with maturities of up to 15 years in Japan and France, 30 years in Germany and 50 years in Switzerland now trade with negative yields.
There are longer-term structural forces at work here as well. Over the past 30 years, estimates of what is known as the “natural interest rate” have declined significantly. The "natural interest rate" is the interest rate that is expected when an economy is at full employment. The decline has been driven by a number of factors including demographics (such as ageing populations), falling productivity and increasing demand for safe, liquid assets. As the natural rate of interest has fallen, prevailing interest rates and the return investors require to buy bonds have both followed suit.
Should we expect negative yields to persist?
In the short term at least, negative yields appear set to continue, with global bonds trading at or near record-high valuations.
In fact, if the global economic outlook deteriorates, perhaps as a result of an escalation of the trade dispute between the US and China, we could see further interest rate cuts and even more demand for safe government bonds. This could lead to an even greater proportion of the global bond market trading with negative yields. Those yields which are already below zero could drop further.
In the longer term, we do not expect negative yields to become a structural feature of the market. We think the phenomenon will dissipate as market conditions and monetary policy normalise.
However, recent experience will have a lasting impact on perceptions of what “normal” monetary policy looks like. What was once viewed as highly unorthodox now has an established place in the central bank toolkit. And as demographic and productivity trends continue to play their part in lowering the natural rate of interest, we may well see negative interest rates appear again in the future.
Why invest in a money-losing asset?
There is a distinction between nominal and real returns. If we are entering a deflationary environment, which many investors fear, a bond with a negative nominal return (before inflation) could still generate a positive real return (after inflation). For instance, a bond expected to lose 0.5% would actually generate a real return of 0.5% if prices fell by 1.0% throughout the economy.
Secondly, government bonds are perceived to be “safe havens” which protect capital better than other investments. With a number of risks on the horizon, such as a no-deal Brexit and an escalation of the US-China trade war, there is currently a very high level of demand for these safe havens. In an uncertain world, a negative yield is perceived by some as a price worth paying for an "insurance policy" that will pay off in bad times.
Finally, not all investors will be planning on holding these bonds to maturity. They are buying at a high price – with a view to selling them on at an even higher price. They may get the opportunity if there is a sharp deterioration in the economic outlook.
While we also have our concerns about the global economy and markets, we are not adding to our government bond positions at these levels. Our research indicates that there are other asset classes with similarly defensive characteristics, such as gold, which offer better value.
This information is not an offer, solicitation or recommendation to buy or sell any financial instrument or to adopt any investment strategy
 Bank of America Merrill Lynch