Why some bond investors don't mind losing money

Deutsche Bundesbank
Kai Pfaffenbach | Reuters

If the German government was thinking of borrowing more money, now would be a great time to do it. Demand for its debt is so strong, in fact, that investors are willing to pay the Bundesbank to take their money.

That's not the way a bond is supposed to work.

The stampede to buy German bonds comes as investors in Europe have plenty of other reasons to fear parking their money elsewhere, like stocks or corporate bonds. Europe' s economy is in the dumps, another Greek debt standoff looms, and sanctions against Russia are cutting into exports.

It's not the first time the yields on German bonds have turned negative, but the fact that the impact is hitting longer term issues shows just how jittery investors have become. (Usually, the longer an investor is willing to lock up their cash in a bond, the higher the yield they get paid.

Here's what's behind the German bond flip-flop.

Wait: Do you have to write a check to the government to hold your money?

Not exactly. Bonds are sold by governments at auction, at which point the interest rate is set for the life of the bond. (That's sometimes called the coupon rate because when bonds were printed on paper, you clipped one of the coupons every three months and sent it in for your interest payment.)

Once the auction is over, you can hold your bond until maturity (and get your minimal investment back) or sell your bond to another investor. That's where the yield flip-flop occurs.

If you invest $1,000 in a five-year Treasury bond paying 1 percent, you'd expect to get $10 a year in each of those five years, plus your $1,000 back—for a total payback of $1,050 over five years. You'll make $50. (We're using simple interest here to keep the math simple.)

Now suppose demand for bonds is so strong that another investor comes along and just has to have that bond. He wants it so bad he's willing to pay you $1,100 for it. That investor still gets only $10 a year (the coupon rate), along with the $1,000 back when it matures. He still gets the same $1,050. But Instead of making $50, he's losing $50. That $10-a-year loss on a $1,100 investment works out to about a 0.09 percent negative yield.

Why would they do that?

Because when some investors get nervous, they don't mind losing a little moneyif they know it's safe. And German bonds are about the safest place to park your money in Europe.

The other option is to keep your money in cash. But then you risk losing spending power to inflation.

But isn't inflation really low right now?

It isin Europe, prices actually dropped last monthbut interest rates are even lower. That's the other way bond investors can lose money. It's been happening in the U.S. on and off since the Federal Reserve stomped on interest rates to get the economy going again after the Great Recession.

Losing money to inflation on a bond investment is a little more subtle. You may get a positive yield in nominal termsthat $10-a- year interest is positive cash. But by the time the Treasury gives you back your initial $1,000 investment, they're paying you with dollars that have lost value to inflation.

The shorter the maturity (remember, they get lower coupons at auction) the more likely your bond will be losing ground to inflation. Yields on two-year U.S. Treasurys, for example, have been bouncing around below 1 percent for much of the last five years, while inflation has been running closer to 2 percent or above. That means the real return adjusted for inflation has been negative.