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I've read that yields on some government bonds in Europe are negative. Who in their right mind would buy a bond that pays negative interest?

It seems like a bad deal alright: You lend me $100, and after a fixed period I agree to give you back, say, $99. Normally, people want to get paid to lend out money; they don't want to have to pay the borrower.

But this upside-down arrangement is exactly what's happening in European countries including Germany, Denmark, The Netherlands, Austria, Switzerland and Sweden, where yields on government bonds with terms of up to five years – in some cases longer – have gone negative. Even some highly rated corporate bonds, including those from BP and Nestle, are trading at a negative yield.

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How did this happen?

"Five years of stagnant economic growth and fears of deflation led the European Central Bank (ECB) to cut interest rates to rock bottom levels back in June, with the deposit rate set below zero," Toronto-Dominion Bank economists Derek Burleton and Leslie Preston said in a recent note.

Denmark was the first to cut its short-term rate below zero, back in 2012, "in order to maintain its currency peg to the euro," the TD economists said. More recently, central banks in Switzerland and Sweden have also joined the negative interest rate party.

Anticipation of the ECB's quantitative easing – that is, the purchase of government securities and other assets from commercial banks to increase the money supply and stimulate growth – caused yields on longer-term European bonds to also fall below zero, the TD economists said.

There are several possible reasons an investor would buy a negative interest bond, the TD economists explained:

  • Risk-averse investors might accept a negative yield as a sort of insurance premium to keep their money in a relatively safe and liquid debt instrument, as opposed to in a shaky bank.
  • In a deflationary environment, the real – or inflation-adjusted – return on a bond with negative nominal interest could still be positive. For example, if a bond is yielding negative 1 per cent, but the consumer price index falls by 2 per cent, the investor’s purchasing power would still increase.
  • If yields fall further into negative territory, the investor could make a capital gain because the price of the bond – which moves in the opposite direction to the yield – would rise.
  • The investor might be speculating that the currency in which the bond is denominated will rise.
  • The buyer of the bond could be an insurance company or pension fund that is required to purchase certain types of relatively safe assets, regardless of their yield.

Could negative yields come to Canada? Real yields are already below zero in many cases: The five-year Government of Canada bond, for example, has a nominal yield of about 0.8 per cent – lower than the annual inflation rate of 1.5 per cent as measured in December. If inflation were to remain at that level, an investor who held the bond to maturity would lose purchasing power.

But nominal yields in Canada probably won't fall below zero, the TD economists said. Deflation is less of a threat here than it is in Europe. And with the Bank of Canada's overnight rate now at 0.75 per cent following a 0.25-percentage-point cut in January, "Canada still has room to lower rates further before it gets close to zero," they said. What's more, many investors are bearish on the Canadian dollar, so they probably won't be snapping up Canadian bonds in an attempt to profit on the currency.

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Still, nominal yields could potentially slip below zero if the Bank of Canada drops its policy rate much lower. The market is pricing in a second cut in March, with a 30-per-cent chance of a third cut later this year.

"If the bank were to ease further than we or the market expects, it is plausible that Canadian yields could also tip into negative territory. However, a likely precursor for this scenario would be an unexpectedly sharp deterioration in Canada's economic performance, which would in turn trigger fears about a sustained bout of deflation," the TD economists said.

"That is certainly not our base case scenario."

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