‘China’s negative yield zero coupon bond, is becoming a ‘big deal’’

China’s first-ever sale of a negative-yield bond drew strong demand from investors seeking exposure to an economy that is returning to pre-pandemic growth rates.

• At a time when the world is battling the Covid-19 pandemic and interest rates in developed markets across Europe are much lower, investors are looking for relatively better-yielding debt instruments to safeguard their interests.
• Last week, China sold negative-yield debt for the first time, and this saw a high demand from investors across Europe.
• As yields in Europe are even lower, there was a huge demand for the 4-billion-euro bonds issued by China.
• China’s 5-year bond was priced with a yield of –0.152%, and the 10-year and 15-year securities with positive yields of 0.318% and 0.664%.
• Last year, China’s finance ministry had expressed concerns over issuing a negative-yielding bond when it issued its first euro-denominated bonds. But it has since become more comfortable with the concept.
• As the only major economy forecast to grow this year amid the COVID-19 pandemic, China has been tapping international markets more often, catering to investor demand for exposure to its economy. Forecasts put China’s GDP growth at about 1.9-2% this year.

What are negative-yield bonds?

• Negative-yield Bonds are debt instruments that offer to pay the investor a maturity amount lower than the purchase price of the bond.
• They are financial instruments that cause purchasers to lose money.
• These are generally issued by central banks or governments, and investors pay interest to the borrower to keep their money with them.
  • They are usually issued in countries with low or negative interest rates and bought by investors who want to keep money safe or avoid worse yields.
• Sub-zero debt is growing and corporate issuers are starting to issue bonds with negative yields as well.
• Negative-yield bonds attract investments during times of stress and uncertainty as investors look to protect their capital from significant erosion.

Why are they in so much demand?

• The fact that the 10-year and 15-year bonds are offering positive returns is a big attraction at a time when interest rates in Europe have dropped significantly.
• As against minus —0.15% yield on the 5-year bond issued by China, the yields offered in safe European bonds are much lower, between –0.5% and —0.75%.
• Also, it is important to note that while the majority of the large economies are facing a contraction in their GDP for 2020-21, China is one country that is set to witness positive growth in these challenging times: its GDP expanded by 4.9% in the third quarter of 2020.
• While Europe, the US, and other parts of the world are facing a second wave of Covid-19 cases, China has demonstrated that it has controlled the spread of the pandemic and is therefore seen as a more stable region.
• Many feel that European investors are also looking to increase their exposure in China, and hence there is a huge demand for these bonds.

What factors are responsible for their high demand?

• High liquidity: It is the massive amount of liquidity injected by the global central banks after the pandemic began that has driven up prices of various assets including equities, debt and commodities.
• Temporary parking of money: Many investors could also be temporarily parking money in negative-yielding government debt for the purpose of hedging their risk portfolio in equities.
• Profitable interest rates: In case the fresh wave of the Covid-19 pandemic leads to further lockdowns of economies, then there could be further negative pressure on interest rates, pushing yields down further, and leading to profits even for investors who put in money at the current juncture.
• Profitable overall returns: In the upcoming times, institutional investors would look at the overall returns after factoring in the sharp gains from equities and commodities and discounting the negative returns on capital being used for the purpose of hedging.
• Maintained purchasing power: The most important reason investors would willingly choose to invest in negative-yielding bonds is when there is deflation, or a sustained drop in the price level for goods and services. 

The negative side of the bond

• When government bonds offer negative returns, investors chase returns in risky assets like junk bonds and emerging market bonds/equities, which can create asset bubbles.
• It becomes hard for banks to make profits as they have to pay borrowers to take loans. Bank find difficult to get depositors to pay for keeping their money with them.
• Negative interest rates discourage savings by forcing people to pay interest for keeping their money in banks.

Conclusion

While successful vaccine trials are showing a light at the end of the tunnel, Fed policymakers see a choppy outlook several months ahead.  With the geopolitical troubles between the US and China now brewing for a few years, investors have been looking for signs of the Chinese diversifying out of their massive holdings of US debt that is held in Treasurys. So far, there has been little, if any, sign of sale of these Treasurys. Just as well, because the first large tranche of Treasurys that gets sold will likely be met by an anticipation by markets that more is to come, which could result in a huge impact on the price.