Getting paid to borrow: The phenomenon of negative-yielding debt
Imagine a world in which the basic laws of physics are turned topsy-turvy and gravity is no longer working. You wake up to see your furniture hovering in front of your eyes. This is a rough equivalent to what is currently happening in the financial system.
During the last few years, an unprecedented phenomenon has gripped the markets. For the first time ever, bond yields are turning negative. This marks a departure from one of the fundamental principles on which the financial system is built: borrowers of money having to pay interest to lenders of money.
Unlike other anomalies that have occurred in the last few years, negative-yielding bonds are completely unheard-of in economic history.
Taking the Netherlands as an example, the figure above depicts the yield of Dutch government 10-year bonds during the last five-hundred years. We can see that at any point in the past, even when inflation was negative, the yield of these bonds would never drop below zero. The first time this happened in the Netherlands was in 2016, closely following similar developments in Germany, Switzerland, Japan, and Denmark.
As the chart below shows, after a brief return to positive yields in the two preceding years, in 2019 10-year government bond yields in Japan slid to new lows while those in the Euro Area and Switzerland plummeted deeper into negative territory than ever before.
What are negative-yielding bonds?
A bond is a debt instrument that gives the owner the right to a certain money income, interest, for the duration of its life. Typically, government bonds are issued by the monetary authorities of a given country in order to raise money to fund their expenditures, and are bought by various institutions and individuals as a source of income. The government pays the purchaser of the bond an annual interest until its maturity date, at which time it redeems the bond according to its face value.
Negative-yielding bonds are debt instruments that require the purchaser to pay the issuer an interest for the privilege of holding the bonds instead of the issuer of the bonds having to pay the purchaser of the bonds an interest for having lent money to the issuer of the bonds.
An increasingly common phenomenon
According to Deutsche Bank, the amount of negative-yielding debt in the world has now crossed $15 trillion. This number has been rising extremely fast -almost tripling in the space of a year- as the phenomenon of negative yields is starting to suck in more and more debt, much like a black hole in space from which nothing can escape (a phrase coined by Max Keiser).
Denmark’s and Switzerland’s entire bond markets are now trading with negative yields, meaning that these governments essentially earn by borrowing money and even 50-year bonds are yielding negative. However, these economies are small compared to for example Germany’s, whose 30-year bond and with it its entire debt market turned negative for the first time ever on August 2nd of this year.
The US government bonds are still all in positive territory, offering investors low returns on their holdings, but due to the continuous decline of interest rates world-wide, analysts are starting to consider the possibility that US debt might follow suit sooner or later.
Not all negative-yielding debt comes in the form of government bonds. The European Central Bank admitted in June 2017 that 12 per cent of the corporate bonds they bought are negative-yielding. This means that certain companies were essentially paid to borrow money from the bank.
Out of the 200 firms from which the ECB had bought such bonds, more than half were German and French. And more importantly, just over half of the bonds bought were rated BBB which is the lowest rating available and generally referred to as junk-bond status.
Why would anyone buy negative-yielding bonds?
Government negative-yielding bonds are bought because they are seen as a safe asset, even though the holder is guaranteed to lose money on holding it. They are also most likely to be issued in currencies whose value is expected to rise over the course of the lifetime of the bond.
Negative-yielding corporate bonds are almost exclusively being bought by central banks, as a way of reducing the debt burden of these corporations and improving their credit worthiness and profitability.
A world turned upside-down
The world of negative-interest rates looks like it is here to stay for at least the foreseeable future, allowing government and corporations to be paid for borrowing money. However, it is unlikely that this privilege will be extended to the average citizen.
The financial world might have gone crazy, but unfortunately not so crazy that free money would be issued to ordinary people. The question that needs answering is what the long-term consequences of negative interest rates are likely to be, beyond the obvious corporate and government debt destruction.
The problem of relying on a limited survey
While it may still be the case that the PMIs will be proven correct in the coming months by newly released data on broader economic indicators―as indeed was the case in 2009―, there are good reasons to believe this may not happen this time around. Simply put, PMIs do not cover the thousands of restaurants who have been forced to close down due to COVID-related measures, or the hundreds of retail shops who are being abandoned in favour of online shopping. This is because the surveys used in PMIs typically only cover a limited number of large companies in order to approximate conditions for the sectors those companies operate in.
For instance, the US services PMI covers just around 400 of the largest companies in selected services sectors, while the broader services index of “real consumption expenditures on services” covers around two-thirds of total spending in the US on services. The differences between the two indices, as shown in the chart above, have been extreme, with the former giving the impression that the economy is in a much better state than it really is. The services PMI crucially fails to capture the carnage in services that was unlike any seen during previous recessions.
PMIs are hinting at structural changes
That is not to say that PMIs should be disregarded. What the out-performances of PMIs could be alluding to is the structural changes taking place in the US and other advanced economies. Much like Amazon has devoured the brick-and-mortar retail competition during the pandemic, many of the other larger corporations have managed to increase their market shares dramatically with changing consumer behaviour, and fiscal and monetary policies that have benefited them disproportionately.
If not for an indication of broad economic conditions, PMIs are still worth looking at for activity among the corporations covered by the surveys. But those celebrating recent PMI readings as proof of a V-shaped recovery for the overall economy might be better off searching for some confirmation, before declaring that the global economy has bounced back from one of its deepest contractions on record.