The Truth About Negative Interest Rates & What To Expect

The peak demand for investors is on the right side of the blue parabola, as is peak supply from borrowers.  Investors would really like an infinitely increasing yield and the higher the yield the more they will invest.  But investors are realistic and know that once the yield is too high, the risk also begins to increase uncomfortably. 

From one investor to the next, this graphic will not be correct, as some investors will only invest with a higher yield than the market offers on low-risk assets, some investors just concern themselves with cash flow, etc. While my graphic may be generally true for the market as a whole, on a case to case basis it will never look like this. Also, there is a limited supply of capital being offered, which is not represented in the graphic.

The second graphic is the same but for borrower's and the supply of bonds being offered in the market.  This shows what I wrote above for borrowers, that if the yield is too high they would rather not borrow because it becomes too expensive and eats up their profits.  They want a lower and lower cost of borrowing capital. The lower the cost to borrow, the more they want to borrow (within limits because they don't want to borrow unlimited amounts of capital without a commensurate ability to deploy and service it, and this is not represented in the graphic).

Borrowers also understand that they won't find any lenders if they go too low and therefore don't even offer to borrow because the risk is just too much for investors not to have a reasonable return to compensate the risk. Even though borrowers would love to go to lower levels below zero, they stop offering long before those levels knowing they won't find lenders. 

This too will change from one borrower to the next because some will have a higher tolerance for higher interest rates if they think their project will give exceptional yields on their investment, others will borrow at any cost, some won't borrow, some will only borrow if the terms are much more favorable, etc.  Here too, my graphic may be generally true for the market as a whole, on a case to case basis it will never look like this.

Market Supply of Funds for Lending by Investors (Demand for Bonds) & Market Demand for Funds to be Borrowed by Corporations (Supply of Bonds)

Both models are exactly the same shape for the market.  However, each and every individual, regardless if investor or borrower, will have a differently shaped curve depending on their need for capital and income, and their appetite for risk versus reward.

The vertical axis represents the percent yield, with the vertex at 0.00%, above the vertex is a positive yield, and below the vertex is a negative yield.  The horizontal axis represents the quantity of both the supply and demand for bonds.  The green curve represents the institutional market, and the blue curve represents the individual market. 

Because individuals generally buy bonds for the income, they will not tolerate a negative yield (with an implied guarantee of loss of principle), therefore, their demand lies only in positive territory.  Individuals generally don’t trade bonds either; they buy and hold to maturity.  So too, the issuers who supply the individual market are aware of this dynamic.  The institutions make up the overwhelming majority of investment in the bond market (households - 12%, foreign investment which includes more institutions - 26%, domestic institutions - 62%), and they are willing to go into negative-yielding territory for the reasons stated above.

It is my hope that this will help clarify what is really happening with the bond market and why, as well as what we may expect going forward.  I am only an individual and I can only report what I see happening, and then try to interpret what lies before my eyes.  I welcome all comments and questions, and I look forward to hearing what you have to say as well as the ensuing discussion that follows.

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Gary Anderson 3 months ago Contributor's comment

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

Mad Genius Economics 3 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.