Markets

How bonds with negative yields work and why this growing phenomenon is so bad for the economy

Key Points
  • About a quarter of the global bond market, or about $15 trillion worth of bonds, offer negative interest rates.
  • U.S. bonds are still paying something, but could go negative if there's a recession.
  • Negative interest rates encourage government borrowing.

Imagine if I came to you with a deal.

Give me $10 today and I'll return $9 to you in a decade or so.

No way right?

This is happening all around the world and on increasing basis.

Maybe you didn't go to Harvard Business School, but perhaps you recall an early lesson from your Junior Achievement class that tells you this is not how it's supposed to work.

You are supposed to put your money in the bank and be rewarded with interest. This is supposed to be wiser than trading your precious allowance at the candy store for an awesome, yet fleeting sugar rush.

Nicholas Colas, co-founder of DataTrek, put it plainly enough: "Bonds are supposed to pay the owner of capital something to pry the money out of their hands."

Nevertheless, some really smart investors around the world now have invested about $15 trillion in government bonds that offer negative interest rates, according to Deutsche Bank. That represents about a quarter of the global bond market.

This financial insanity is overtaking the world because bond prices are skyrocketing as stock prices are tanking. As more money flows into bonds, their yields go down — even below zero in some cases.

The good news is that U.S. Treasurys, while hovering near all-time lows, still pay at least something. The 10-year was yielding 1.62 percent on Wednesday. Still, that's low enough to stymie financial educators as they try to convince children that they should put off instant gratification and save at least some of their allowances.

Some market observers are now warning that the U.S. could be paying negative bond rates, too, if there's another recession. Currently, our central bank, the Federal Reserve, has set its benchmark rate at 2.25%. When the economy turns south, the Fed typically lowers rates by as much as 5 percentage points to reignite borrowing and spending.

But where else can it go after it hits zero?

Paying any government to take your money is as irresponsible as feeding children nothing but candy bars. It's what you might call a "moral hazard," but this term seems to have been eliminated from the economics texts following the bailouts of reckless financial institutions in the 2008 financial crisis.

Negative interest rates, and even super-low interest rates, are only going to encourage more government borrowing. This in turn allows politicians to make all kinds of grandstanding promises — until one day when the debt pile gets too big, interest rates return to historically normal levels, and taxes go up to pay for it all.

So why does this happen?

Institutional money have investing guidelines they have to follow while shepherding all their billions. Those guidelines often require them to buy bonds. The demand for these bonds is rising sharply — so they take the deal of the day.

In the end, it's not a good sign for the economy.

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