If financial theory is grounded in one principal, it’s the “time value of money,” or the idea that individuals prefer consumption today over consumption in the more uncertain future.
In order to encourage the deferral of consumption, borrowers must pay lenders, and it has always been assumed that interest rates are “bound at zero”. But as has repeatedly been the case since the financial crisis, the theory is being challenged by the practice.
The last year has seen a proliferation of bonds trading with a negative yield, mainly in Europe. In effect, creditors are having to pay in order to lend money, and this has a number of implications for investors.
Currently, 25% of the European sovereign bond market is trading with a negative nominal yield. In France, government bonds of up to 3 years carry a negative yield; in Germany, bonds up to 8 years do; and in Switzerland, bonds up to 10 years. Even more striking, there are examples of corporate bonds with a negative yield. For instance, back in February, yields on the bonds of Nestle turned negative.
Why would anyone pay to lend money? There are several reasons, most a function of the unusual economic environment prevalent in Europe.
First, negative yields may make sense if you expect a significant decline in prices. Under deflation, real (or inflation-adjusted) yields could be positive even if nominal yields are negative.