How $18T in Negative Yielding Debt Makes Perfect Sense

Simple examples explained in plain english

According to Bloomberg, by the end of 2020 we had $18T in negative yielding debt. The strange game theory of how bonds behave in an unhealthy environment trending toward if not beneath the zero bound: 0%. Therefore, it is easiest to exemplify by storytelling just above and below the zero bound. There is nothing normal about negative yielding bonds but it is nonetheless explainable. First let’s understand how bonds work.

How Bonds Work

If you buy a $1000 of a bond yielding 1% and the Fed lowers the rate to 0%, your bond at 1% is more valuable than the new 0% bond. It is obviously better to collect $10 than $0. But to understand how negative rates make sense you need to accept the other characteristic of bonds: they are tradable assets, like stocks. You can determine the value of a bond by comparing your bond’s yield against the current yield. In the example above if you purchased your bond for $1000 then the rate dropped to 0%, you still get 1%. That means the face value of your bond is now worth more on the open market. For this example’s sake, let’s say you can sell your 1% bond for $1010 now. That extra +$10 is your premium if you decide to sell it. If the opposite happens and the interest rate goes up to 2% then your bond is worth less, let’s say $990. That deficit -$10 is a discount. Note these numbers are directionally, not literally, correct for the sake of simplicity.

Here’s where it gets weird. If the rate goes negative, that means the bond will pay you back less than you put in originally when the bond term ends. But, if you buy a -0.25% yielding bond that drops to -1.00% the value of your bond still rises. Your gut feeling is correct: “this doesn’t feel right”. And your logical brain is also right: “this kinda makes sense in strange twisted way”. The face value of the bond will rise as long as (1) the rates continue to drop and (2) bondholders can find buyers.

When it comes to negative bonds, ignore the obvious (coupon rate) and focus on the open market (face value) dynamics.

Now we can zoom out and look at the bigger bond picture. If there are $100B in the bond market and $20B are yielding between <1%, what happens if raise the rates to 1.25%? Answer: you blow up existing bondholder positions by making their investments worth less. In a healthy bond market (>5%) new buyers will come in and scoop up the higher yielding bonds because it’s still attractive at those healthier rates. But we live in times where the majority are overleveraged and it’s getting harder to convince investors to buy bonds. It’s an asymmetrical risk, in the worst sense, if the government raises bond yields.

Here are the effects of a rate increase on the bond market:

1. Small rewards. Moving from 1% to 1.25% isn’t exactly a big incentive, especially since it still doesn’t outpace inflation. It’s a marginal improvement.
2. Wrong side of the trade. All bondholders <1.25% are now in pain as their bonds are now selling at a discount.
3. Alligator arms: potential buyers get nervous in fear of yet another rate increase. If you go ahead and buy the 1.25% bond, what gives you confidence they won’t raise the rate to 2% tomorrow?
4. Scaring away your customers. The government needs other people to buy their bonds otherwise they will need to “eat their own product” and the government’s balance sheet will expand uncomfortably and rapidly.

Put another way, raising rates when you near the 0% threshold in an overleveraged, unhealthy economy is a perilous bridge to cross. Although negative rates make no sense, it’s the better of two options for short term survival. As long as the bonds flow new money can be pushed into the economy.

The pitfall of lowering rates is devolving into an economic state where rationality decays and unpredictably strange behaviors are certain to follow — panic. The point is, if no one buys our bonds… we’re in deep shit. Many countries do not want to go into negative territory but what choice do they have? Only the USD can be printed without severe consequence. So we do it because we can. It is an abuse of power and privilege.

Why Bonds Matter

Bonds are the building blocks of every economy. When governments need to raise new capital they issue bonds. Those bonds are purchased and the dollars exchanged start trickling into the system. It’s important to note that those dollars end up downstream funding companies, buying homes, and purchasing stock (and every economic transaction in between). Because bonds serve as the foundation of our economic system, every “sexy” asset purchased at a higher level is ultimately affected by the foundational lower level bonds. Put another way, when the bond market catches a cold the economy catches pneumonia. We are in a fragile state, regardless of what the media says, and the last thing we need is a panic in the bond market.

This is why the Fed announced rates will remain unchanged through 2022. They are signaling to the market: “don’t worry, we will not blow up your precarious positions.” Since the United States dollar is the global reserve currency we have the privilege of printing an unlimited amount of money. That means the Fed has the superpower to manipulate bond markets by purchasing their own bonds if needed to implement yield curve control.

The yields in the bond market are not dictated by the Fed, it is based on supply and demand. The Fed can control bond yields by purchasing (demand side) bonds to keep the rates artificially low. Printing massive amounts of money is not so simple for other nations as they will ultimately be on the hook for the money they print as it is not nearly as universally in demand as the US dollar.

Here are the effects raising rates will have on main street:

1. Lending and borrowing will tighten as interest rates rise. Money that is harder to access means spending decreases. This potentially leads to a deflationary spiral as money circulates less freely.
2. Zombie organizations and individuals: those operating at the margin face insolvency risk. By definition, a zombie company’s interest payments outpace their income. Raising rates accelerates this downward spiral into irrecoverable debt.
3. A deflationary spiral on a macro level plays out like dominos with a cascade of failures. The terrifying part is the global economy is so intertwined that there is no clear end in sight. Extreme intervention is necessary to prevent freefall. This explains why the government overshot in 2020's massive stimulus packages and also why it continues into 2021. Economic freefall is indistinguishable from pure chaos.
4. Deeper wealth inequality: banks will only be comfortable lending to folks that are highly credit worthy and low default risk — the 1%. The ultra rich, who already own the vast majority of assets, get an exclusive shopping spree feasting on the corpses of those zombie assets alluded to in point 2 above.

The first two pose systemic risks. The last two pose revolutionary risk since capitalism only works if the game is worth playing, so to speak. When you play Monopoly and one player owns 90% of the board, the remainder of the game is just academic. Most players will cry foul and ask for the game to be reset (aka revolution). This is why governments around the world have been touting their latest slogan: The Great Reset.

People will revolt if the game is unplayable.

Keep Lowering Rates

The act of raising bond yields in our economic environment is akin to walking through a minefield while wearing a protective cup. It doesn’t end well. The less psychotic path is to continue lowering rates.

Here are the effects lowering rates will have on the bond market:

1. Don’t scare the customers. Governments need to maintain the charade that someone, perhaps the government itself, will buy these disintegrating bonds at higher face values. Face values must offset the missing coupon rate while also factoring inflation risk. Put another way, governments are playing a confidence game by knowingly selling a bad product.
2. Suicide squeeze: bonds at negative or zero rates as a lot from buyers. Governments are asking buyers to extend their trust and faith beyond reasonable limits. Risk being the fool with little upside. As the saying goes: “If you believe that, I got a bridge to sell you”.
3. Old habits die hard. Since 2008, the “Bond Experts” have made their entire careers off this one-directional trade: buy bonds, wait for rates to drop, then sell for a premium. Rinse and repeat. This is made possible because bonds have consistently declined since 2008. Will the creature of habit recognize the game morphs at the zero bound?

Here are the effects lowering rates will have on main street:

1. Keep the money flowing. The trouble starts when the money stops. Governments around the world are entering uncharted waters doing the unthinkable to bond rates because it means the money keeps flowing on main street.
2. Inflation. Money will continue to flow but things will get increasingly difficult as inflation will outstrip real production. Governments are in denial about this fact, at least they want citizens to believe inflation is under control.
3. We’ll pay you. This is one of the strangest byproducts of negative rates. If you get a negative interest rate loan you pay back less than you originally borrowed. This blows up every bank as it makes their core business unprofitable. Bizarre right?

Keep Your Eye On The King

Common sense is all that is required to understand negative and zero rate yields are not sustainable. Governments have their backs against the wall choosing between bad options. There is a phase shift on the horizon that will force leaders to show their true nature. Governments can be personified on a spectrum between the wise king and the mad king. It is your personal responsibility to identify the ongoing state of your government with the aim to answer one question: what type of government do I have? The wise ruler has the awareness that more of the same action will not suffice and will seek change through evolution, possibly even requiring transformation. The mad ruler will act to constrict your freedom and double down on existing plans, ignorant of the reality that times have changed and the old plan no longer serves the people.