For the many of us who assumed that interest rates and bond yields could not fall below zero, the past few months have proved us spectacularly wrong. The European Central Bank (ECB) set a deposit rate for commercial banks of -0.2% late last year and others have followed. Denmark’s central bank now has a deposit rate of -0.75% and in February, Sweden’s Riksbank also cut one of its main interest rates below zero.

In European government bond markets, meanwhile, yields have been heading in the same direction, with many government bonds with maturities of five years or less now trading with negative yields – meaning that buyers who hold them to maturity will receive back less in capital and coupons than they spent purchasing them. Even Germany’s ten-year Bund now carries a yield of about 0.3% – lower than the famously miserly Japanese ten-year equivalent. 

With bond yields this low and prices therefore so high (bond prices and yields move inversely), respected commentators such as Robert Shiller of Yale argue that a bond bubble has inflated in the developed world.
"We’re now seeing a weight of money at the short end as well due to the increasing regulation that banks are now faced with" So why are interest rates and bond yields below zero? And why are investors still apparently queueing up to buy bonds at negative yields? Richard Batley, Senior Economist at Lombard Street Research, points out that negative nominal yields simply represent a step further along a road we have been on for years. “There’s really nothing magical about zero on a nominal basis because real rates have been negative for the past six years,” he says. However, that does not mean that negative nominal rates are unimportant. 

Downward pressure There are three broad reasons why interest rates and bond yields in Europe have turned negative: economic performance, central bank action and technical factors.

Both Batley and Anthony Doyle, a member of the fixed-income team at fund manager M&G, argue that low growth, low inflation, weak demand and high levels of debt are crucial reasons for the downward pressure on bond yields in the eurozone.

-0.2% 
The deposit rate that the ECB set for commercial banks late last year

0.3%
The yield that Germany’s ten-year Bund now carries

€1.1tn
The amount in mostly government bonds that the ECB decided to buy over the next 18 months
Although the quantity of debt in the private sector may have come down in absolute terms, economic output has declined faster, leaving those countries affected carrying a higher debt burden. In these circumstances, extremely low borrowing rates become essential to making debt burdens sustainable.

By the same token, negative central bank deposit rates are part of the official effort to discourage commercial banks from hoarding cash and instead push them to lend to the real economy, thereby helping to fuel growth that will ultimately enable these economies to grow out of their debt problems. 

But in spite of this, demand to borrow remains muted and the weak outlook for inflation is also bearing down on bond yields, says Doyle. “We no longer have an inflation premium or a term premium in the government bond market. You’re not being paid to lock your money away for five years any more than you would be, say, for a year.”

Another factor pushing bond yields lower, especially in the southern eurozone periphery, he adds, is the collapse in the premium that investors expect to protect them against the risk that inflation will erode the value of the fixed income from a bond portfolio. 

Official response Ironically, it is not only the eurozone’s economic struggles that are producing negative yields, but also the official response to those troubles. The ECB’s decision to buy €1.1tn of mostly government bonds over the next 18 months has hugely increased demand and therefore pushed up their prices, which in turn forces yields ever lower, as well as sharply decreasing the exchange rate of the euro against major currencies such as the dollar, which should help eurozone exporters become more competitive. 

“I think a very strong reason [for this] is simply the fact that you’ve had a massive buyer [of bonds] come into the market in the ECB,” says Doyle. “It is trying to expand its balance sheet [by buying bonds] in a world where Germany, in particular, and Europe generally is trying to implement austerity, which means less supply.” With yields already very low, the ECB’s emergence as a major buyer has been enough to push yields below zero. 

The ECB, however, is not the only willing buyer at these levels. Doyle points to a series of technical and regulatory factors that are ensuring that investors will continue to buy government bonds even when yields turn negative. 

Regulation is forcing banks to build larger capital and liquidity buffers, which requires them to hold cash or high-quality shorter-dated bonds and contributes to a ‘savings glut’ of money looking for safe havens. “Investors are very familiar with it at the long end of the yield curve where pension funds and insurance companies have been matching liabilities,” he says. “We’re now seeing a weight of money at the short end as well due to the increasing regulation that banks are now faced with.”

Similarly, shorter-dated government bonds are in increasing demand to act as collateral for banks’ derivative exposures, points out Doyle. “So it’s less about it being a profitable investment and more about institutional investors being forced to own these types of government bonds.”

Pension schemes Defined benefit pension schemes are also continuing to increase their exposure to government bonds despite extremely low yields, says Treeve Coomber, Senior Investment Consultant at Towers Watson, which advises many such schemes. There is no regulation that formally forces them to do this, he says, although many will have been encouraged to go in this direction by The Pensions Regulator or their corporate sponsor. 

Bond yields are crucial in calculating the value of assets that a defined benefit pension scheme needs to hold in order to meet its future obligations. The more yields drop, the greater the value of assets the fund needs to hold and, in practice, the bigger the deficit has tended to grow between the value of the assets and the extent of the liabilities. The experience in recent years has been that even though pension schemes have benefited from rising equity prices, the plunge in bond yields has more than offset this, leaving schemes with bigger deficits to address. Many have therefore decided to continue buying bonds to protect against the risk that yields will fall even further. 

“Pension funds are not buying these assets because they see them as very attractive investments,” says Coomber. “They see having these, along with other, higher-returning assets – whether that’s equities, corporate bonds, high-yield or property – as a good balance to manage their risks.” 

He believes that current, extremely low bond yields may be a sign that the market expects returns from all assets to be low in future. “One thing we are certainly telling our clients is that we fear we might be in an era of low returns,” he says. “One way you might think to get yourself out of this situation is to take more risk. We’re uncertain whether that’s going to work over the short term.”

M&G's Doyle concurs. “The old days of 5% interest rates are long gone,” he says. “It’s a relative game, and the game starts with government bonds – the risk-free rate. Today, that’s negative so it cascades through the asset classes.”