Negative Yields on Bonds
|September 10, 2012||Posted by Fred Foldvary under Editorials|
A “bond” is a debt instrument or IOU note. If you lend money to an organization, you obtain a certificate, usually in electronic form, in which the borrower promises to pay the holder funds at some specified amount, until the bond matures or ends, at which time the principal or initial payment is returned. The yield of a bond means the annual rate of gain. If you buy a bond for $100, and you obtain $4 per year from the bond issuer, the yield is four percent.
The bond yield is loosely referred to as “interest,” but it is not pure interest. Scholarly economists, business people, and the general public regard interest as a periodic payment by a borrower to the lender, for the purpose of shifting a purchase from the future to the present.
Pure or economic interest is based on “time preference,” the tendency of most people most of the time to prefer goods in the present day rather than waiting to buy it in the future. Suppose you want to buy a car, and have no savings. You could either wait several years to save up the payment, or else buy it now and pay a premium or extra amount as interest. Hence interest is the payment made to shift a purchase from the future to the present day.
During the era of the classical school of economics, until the end of the 19th century, economists confusingly called the yield of capital goods “interest,” hence calling the three-factor return rent, wages, and interest. In the late 1800s and early 1900s, economists developed a better theoretical understanding of time preference and also of the distinction between financial capital and the input category of capital goods. Thus today the economic meaning of interest is that based on borrowing, although those stuck on 19th-century terminology continue to use “interest” as a yield of capital goods, while calling the produced factor just “capital” in order to meld interest on financial capital with the yield of capital goods.
The “debt service” is the total periodic payment made by a borrower. Part of this is economic interest, but much of the rest includes a payment for overhead and profit, a premium for risk, a premium for anticipated inflation, and a premium for taxes. The existence of these premiums is why the debt service on credit-card debt is so high. The yield of a bond is therefore not just the pure interest but also premiums.
To understand negative yields, we also need to distinguish between nominal and real interest rates. The nominal rate is the quoted rate or the yield as the annual money gain divided by the market value of the bond. The real rate is the nominal interest minus the inflation rate. Pure interest equals the nominal rate minus all premiums.
A negative nominal interest rate means that rather than the borrower paying to the lender, the depositor or lender pays the bank or borrower. Negative nominal interest rates are rare, since time preference is universally positive. But today, the government-bond yields of several countries have turned negative.
Switzerland has had one of the best economic policies in Europe, and the Swiss franc has been one of the best currencies, and so it has in the past appreciated relative to the major currencies. Swiss banks are also known as safe and protective of privacy. The banks of Switzerland have therefore been a magnet for funds from around the world. So favored is the Swiss franc that two-year Swiss government bonds have had yield of minus .36 per cent.
But the pure interest rate in Switzerland is not negative. The Swiss time preference remains positive. What is going on is that because the rest of the world is perceived to be highly risky, the risk premium in Switzerland is negative. Thus the safety premium is positive, and what people are paying is a fee for safety, which is greater than the pure interest rate, making the nominal yield negative.
Globally, the pure interest rate is about two percent. In a pure free market, deposits that are completely safe, with zero inflation and taxes, would receive a two percent rate. Thus a negative nominal yield below two percent implies that there is a premium for safety being paid by the depositor, who is also a lender.
Germany’s two-year bonds also fell into slightly negative nominal yields in 2012. The short-term yields of the government bonds of Denmark, Finland, the Netherlands, and Austria too have turned negative. As depositors take their money out of the banks of the high-risk debt-ridden countries, the bonds and banks of the negative-rate countries are perceived as relatively safe. The German 10-year government nominal bond yield was 1.35 percent, lower than the inflation rate of two percent, hence with a negative real rate. The nominal yields of U.S. bonds are also below inflation.
Negative nominal bonds yields cannot persist. Money managers may park funds with zero or slightly negative nominal yields, but will then switch to dividend-paying stocks that have bit of risk but much higher yield, and also to real estate that has a positive cash flow. Indeed, nowadays, the real rate of interest is better observed by the ratio of net long-run real estate rentals to real estate prices than by the yield of bonds.
Because in the long run, nominal yields will turn back to positive when price inflation rises, some speculators hold derivatives that rise as bond prices fall. Negative real interest rates indicate that there is some short-run economic problem, and negative nominal rates indicate a very serious economic illness. The developed countries have been hit with an epic recession and the consequences of continuous high budget deficits, and these problems are not being remedied but only treated with central-bank bond-buying band-aids. The negative yields are a sign of another financial waterfall up ahead, while the fiscal ships of state are floating down rivers of no return.
Only the replacement of punitive taxes (and restrictions) with an economy-enhancing land-value tax can save the decaying developed economies, but nobody is talking about that other than the few followers of Henry George. I would blame economists for ignoring the obvious remedy, but I do not want to place blame on human beings with the mental dysfunction called “cognitive dissidence.” They can’t help it, and so they cannot help us.
In my judgment, disaster is still a few years away, because the short-term treatments can postpone the crisis. But bond-buying and monetary inflation by central banks will eventually result in price inflation, which will turn nominal bond yields back to positive, and the inflation will also bail out real estate and reduce the real value of debt. But that will not solve the deficit problems, and the monetary expansion and the inflationary subsidies to land values will make the next bust even worse than the Crash of 2008.