It used to be thought that there was “zero bound” on interest rates—central bank monetary-policy rates, in particular. Now we know otherwise. With negative-rate policies by the European Central Bank (ECB), the Bank of Japan and others over the past two years, zero is no longer a bound; it’s just another number.

Consider that long-term interest rates in most developed economies have plummeted. In fact, 31% of all developed-market bonds (by par value) are currently trading with negative yields (Exhibit 1).1 As a result, investors aren’t only buying government bonds—but also paying a price for the potential of owning those bonds. This may not be an appealing proposition for income-starved investors.

We believe yield seekers may therefore have three choices. They can:

  • buy longer-maturity bonds, which would increase interest-rate risk;
  • buy bonds of other sectors, such as corporates, which would increase credit risk; or
  • buy bonds of issuers in countries with higher (or at least positive) interest rates.

negative yields, all government bonds issued by developed markets have negative yields

Each of these options poses different risks and opportunities. The primary opportunity in all of them is the potential for yield in an exceptionally low-yield environment. The risks, however, are different in each case.

  • Buying longer-maturity debt. Without getting into bond math and details, let me just remind readers that longer maturity bond prices are more sensitive than shorter-term bonds to every move in interest rates. For example, if interest were to rise by 1%, the price of a 2-year U.S. Treasury bond would decline by just under 2%, whereas the 10-year U.S. Treasury bond would fall by about 9%.

The good news is that bonds with positive yields have a bit of cushion, which makes an increase in yield a bit less painful. We call it the “breakeven yield move,” whereby returns can remain positive even if a bond’s price declines. For example, if 10-year U.S. Treasury yields go up by about 0.2% at today’s interest rates, investors’ total return would be no better than zero. That’s not a lot of cushion, to be sure. Yet if a bond’s yield is zero or negative, there’s no cushion at all, so an increase in yields would hurt even more. For example, if you buy a 10-year bond with a yield of zero, and yields move any higher, your total return would be negative right away.

Exhibit 2 shows how much it would take for yields to move higher before a bond owner starts to see the total return decline to zero (i.e., a breakeven). Short-maturity bonds have less interest-rate sensitivity, so it generally takes larger yield moves for them to start losing money—unless, of course, they are negative already, in which case the bond owner loses money to begin with.

negative yields, short-maturity bonds offer more cushion to higher yields than long-maturity bonds

  • Buying bonds of other sectors. Corporate debt or sovereign bonds with higher yields offer higher prospective returns, but one needs to be diligent and vigilant in analyzing their credit and monitoring positions in those bonds. Some higher-yielding bonds are subject to significant political and economic risks, while others have higher yields because of different factors. Exhibit 3 shows a range of 2-year government bonds of different countries to illustrate the spectrum of yields available to the fixed-income investor globally.

negative yields, the yields of 2 year government bonds vary greatly worldwide

Negative Yields and Investment Benchmarks

We look to avoid investing in assets with negative yields—an approach we believe should benefit investors in the long run by ensuring their investments do not begin “in the red.” However, there is a relative performance cost of not owning negative or extremely low-yield assets at times, since investments may underperform a benchmark that has many negatively yielding bonds.

Since the ECB moved to negative rates, some bonds that traditionally performed well during bouts of risk asset volatility, such as German Bunds and now Japanese government bonds (JGBs), have posted positive price performance even though their yields are negative. This “benchmark risk” is something investors have to contend with in the short term. However, in the longer term, as we’ve shown earlier, the potential for negative returns from negative-yield assets is quite high.

A case in point is a widely used international bond benchmark: the Citi Non-U.S. World Government Bond Index (Exhibit 4). A third of that index comprises JGBs, while a quarter of it comprises European countries, where negative rates are also pervasive. Given this year’s “risk-off” mode—and the strong rally in negative-yield assets (see Exhibit 5 for one example)—those benchmarked to this index would have underperformed. Yet we believe that most investors will be better served in the long term by not owning assets at negative yields, regardless of short-term performance.

negative yields, the citi non us world government bond index has a significant portion of bonds from countried with negative yields

negative yields, german 5 year bobl yields began the year in negative territory and have since declined

*BOBL is an acronym for bundesobligationen. This translates to ‘federal obligations’ in English, or German bond.