The Truth About Negative Interest Rates & What To Expect

On the other hand, if the yield falls below zero, borrowers may still have access to borrow capital for the reasons stated above, namely that relatively the yield may be higher than the other available options and also that the bond traders think they'll trade a return that is greater than the negative yield loses.  Remember, to borrow a phrase from Grant Williams, certain financial institutions are legally required to hold this "return-free risk".

Here too, however, there is an inflection point because borrowers know that lenders only lend at a profit.  If the yield will lose more than the trade can gain, borrowers will lose access to capital.  knowing this, they will slow the pace of how much they offer as the rate falls further below 0.00%.

In addition, eventually, institutional investors will rally together to force Congress (or their own sovereign legislative body) to change the laws regarding how much of this they must be forced to legally own; they have a fiduciary responsibility to fulfill pensions, life insurance claims, annuity promises, and the like, and with negative-yielding bonds making up the supermajority of their portfolios, they can not possibly fulfill all those promises.

As far as borrowers are concerned, they really don't care if inflation runs hot because inflation favors borrowers as it becomes cheaper and cheaper to pay back their creditors.  Borrowers are more concerned with deflation because it will become more difficult to pay back the loans, which is complicated by the fact that people will have falling income with deflation and won't be able to spend as much on the products and services which the borrowers offer.

Low rates are problematic. Low rates discourage saving and investing, and people will tend to spend their cash faster instead.  This sends a false signal to businesses who will then think that because interest rates are so low and because consumers are spending faster, they should actually try harder to borrow the cash at the lower rate to grow the business or invest in efficiencies to further increase profits...they should strike while the iron is hot.  So too, if interest rates rise too high then businesses get a false signal because consumers will save more and businesses will see less profits, and therefore borrow less at the higher market rate in order to conserve capital.  They’re sort of right to try to borrow with lower rates because they can borrow the same amount of cash for lower service.  So too, higher rates make it harder to service the same capital.

In reality, though, businesses should be borrowing when rates rise, because consumers will invest their savings with the higher offered nominal rate. With the long term profits the savers make on the higher yields, they'll be able to buy much more stuff, even right now with the higher income.  This is similar to the stock market wealth effect, that when stocks reach lofty levels, people feel more wealthy and tend to spend more.  So too, when interest rates fall, businesses should tighten their belts because that will signal consumers are getting ready to invest less and therefore spend less in the long run, not the opposite as they often misinterpret.

Another point to consider is that if I use a bond calculator to find the price of the bonds I hold, it will tell me the price of my bond relative to the market for bonds. Even if my bond has a negative yield, as long as the market yield is lower than mine, my bond is worth more in the market.  The problem is that a bond calculator is not calculating the net present value of all future cash flows in conjunction with what I’ll be paid back at maturity for the bond.  Rather, it only calculates relative market price, which is useful only to know approximately what I can sell it for right now.

Unfortunately, that bond calculator misses the point for bond investors who rely on the future cash flows for income.  For me as the investor, who needs the future cash flows to pay my expenses, I need to calculate the net present value of the bond.  I can't calculate the NPV because with a negative interest rate, the bond will have a negative price instead of positive.  For example, if I invest $1000 for 3 years at -5.00%, the NPV will be almost -$1200. If my bond has a negative yield I get back less than what I invested, which is the complete opposite of what I want. 

I have included an investor/lender demand graphic representation (not drawn to scale) of the demand for lending in the form of bonds.  It represents what I’ve written above, that if the yield is too high, investors will not invest.  If it is too far below zero, so too they won't invest but for different reasons. 

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Gary Anderson 7 months ago Contributor's comment

Nice take on bonds. Banks don't want nominal negative bonds and neither do individuals.

Mad Genius Economics 6 months ago Author's comment

Thanks for reading and commenting Gary. I appreciate your feedback and contribution to the discussion.

I don't think anyone wants negative yielding bonds because of the guaranteed loss. Imagine if I asked to borrow $10 on condition I have to pay you back $9.75. You might as well just give me the quarter and call it a day without having to risk the other $9.75 not getting paid back.