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Sub-zero bonds?

La deuda europea alcanza precios históricos

For the first time in history, Eurozone countries are selling their fixed-rate bonds at negative interest rates. How have we reached this surprising situation, and why is demand for this debt still increasing?

9 december 2015

The Spanish Treasury issued 3.515 million euros worth of 12-month bonds, last 17th of November. Not a particularly newsworthy occurrence, if not for one historical detail: this particular fixed-rate bond delivered a yield of -0.046%. The Spanish state is effectively charging investors for lending it money. 

This perplexing situation is not, however, all that unexpected: 3, 6 and 9-month bonds have already been selling at negative rates for a few months. Most European governments (in particular EU-15 countries) are issuing long-term bonds with negative yield, and Switzerland has even auctioned their 10-year bonds below -0.3%. And rates keep plummeting.


¿How did we get here?

This anomaly can be traced back primarily to the European Central Bank and their plan to restore credit flow in the Eurozone. It began with a decrease in the deposit rates they offer, cutting down to -0.2% (the first central bank to do so), and continued with an aggressive Quantitative Easing plan, that is, an extensive acquisition of assets – particularly government bonds – all the way through 2016, at a value of over one trillion euros. Increased liquidity to fight back the fear of continued deflation.

The theory of Quantitative Easing

The theory of Quantitative Easing, step by step (via the BBC)

Non-Eurozone countries (Denmark and Switzerland, to name two) have also applied aggressive monetary policies in order to balance the loss in value of the euro with the strength of their own currencies, as well as to battle deflation (for example, the Swiss National Bank shot interest rates on deposits down to -0.75% from 0.25%).

What happened?

The desired effect was to make sovereign bonds and stockpiling less desirable (with banks and financial institutions particularly in mind), translate that extra liquidity into a higher supply of credit and, as a main goal, push inflation closer to 2%. But the demand for bonds hasn’t really been hurt: basically, losing a small percentage of funds in interests is still more attractive to investors than lending it to a business at a higher risk. In practice, there are some points that need to be cleared:

1.Even though bond yield until maturity is currently negative, that doesn’t mean that a profit can’t be made. If interest rates keep on dropping (as expected), the value of older bonds increases on the secondary market (a yield of -0.2% is still more attractive than a rate of -0.3%, for example). In fact, most reports point towards a further acquisition of bonds by the European Central Bank, this time below the -0.2% limit they self-imposed, which could entail an even steeper fall for bond rates. A dream scenario for speculators.

2.The consumer price index (IPC) in Spain is negative, -0.7% yearly. While that has no effect on nominal value, in terms of real returns a bond would actually be more valuable now than when auctioned off, due to deflation.

3.In certain instances, the “lost” amount would still be less than the cost of a deposit, and with considerably less risk.

It wouldn’t be too odd, in these circumstances, to watch 3 and 5-year state bonds slip into red in upcoming months, following in the steps of Spain’s European neighbours. The growing consequences for corporations obliged to invest in public debt are still uncertain, but the dangers for pension funds and others should rates keep falling are, at the very least, worrying. The question remains: just how low can they go?