In mid-March yields on the sovereign debt of several euro zone nations turned negative. The notion of investors accepting negative interest rates may seem bizarre, but it is not necessarily irrational. Readers should not be alarmed or change their strategy should negative nominal rates persist overseas or emerge in the U.S. But it is important to understand this phenomenon and its implications in the context of a well diversified portfolio strategy.
Interest rates are negotiated by buyers and sellers, so bond investors are weighing their alternatives and choosing to buy securities with a promised return (yield to maturity) that is negative. Bonds cannot provide negative coupon payments, but German bond investors are in effect agreeing to pay more than €10,000 in exchange for a promise to be repaid only €10,000 when the bond matures, with no coupon payments in between. These are in effect zero coupon bonds promising a negative return if held to maturity. Similarly, bonds making coupon payments provide negative returns when their prices are bid high enough to provide a negative yield to maturity when all cash flows are accounted for.
Rational investors may well be tolerating negative returns as the price to be paid for security. Global risk is arguably very high. The fate of Greek debt remains in doubt, and fears persist regarding the sovereign debt of Spain and Italy. Investors who prize safety face limited options. Holding large sums of euros “under the mattress” is impractical and unsafe, while holding currency in a bank vault is subject to the limits of depository insurance. In this environment German bonds, which bear much lower risk of default, may be perceived as a safe alternative, even if it means paying 0.20 percent to own them.
Also In This Issue
Inflation Expectations And The Investor’s Dilemma
Qualified Dividends vs. Ordinary Dividends
The High-Yield Dow Investment Strategy
Recent Market Statistics
The Dow Jones Industrials Ranked By Yield
Recommended Investment Vehicles
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