What does negative interest rate mean? In a negative interest rate scenario, you are charged to keep money in a bank account. Suppose, if you deposit Rs 100 in bank account and interest rate is -1% then you will be holding Rs 99 at the end of the year. Sounds funny that you will be paying money to the bank for your deposits, but in reality Central Banks of Europe and Japan have cut interest rates to negative. Banks in Europe are paying negative rates to savers on their deposits. Bond yields in Japan and Europe are trading in negative territory. Table 1.
As per published data there are over USD 9 trillion of bonds that have negative yields. Now when a bond offers a negative yield, the buyer of the bond will not get back the amount that was invested. In Germany, one-year government bond yield is around -.516%. Investors buying this bond will get less Euros at maturity than the capital they have invested. On face value these negative rates do not sound a good deal for investors but yet there are many investors piling onto negative yield debt across countries such as Germany, Denmark and Japan.
Why are Central Banks keeping interest rates negative?
Negative interest rate by a central bank is a signal that traditional policy measures are proving ineffective and new policy should be explored to boost the economy.
Central banks have brought interest rates to negative as part of their strategy to stimulate growth and to penalize banks for parking cash with them. In theory interest rate below zero should reduce borrowing cost for companies and households, driving demand for loans.
In Denmark and Switzerland, the main objective of the respective central banks to reduce interest rates to negative is to prevent their currencies from rising too much in value. The objective of negative rate is to discourage investors from buying their currency.
Reasons why investors buy bonds at negative yields
· In a Deflationary environment, inflation adjusted returns on a bonds with negative nominal interest could be positive. For example, if a bond has negative yield of 1% and the consumer price index falls by 2% the investor purchasing power still increases.
· If bond yields fall more into negative territory then investors earn capital gains on price appreciation of the bond.
· Investors speculating appreciation in the currency of the country where bond yields are negative. For example, you have 1 USD which you converted into Yen and exchange rate is 100. You will have 100 Yen to invest and you invest in negative interest rate bond for 1 Year. At the time of maturity, suppose you get 99 Yen while USD/JPY exchange rate is 95. It implies that you only need 95 Yen to buy 1 USD and after maturity period you have 99 Yen that enables you to buy 1.042 USD. You gain 4.2% on Yen appreciation despite losing 1% on investing in negative yielding bond.
