Why Would Anyone Buy Negative Interest Rate Bonds?

By Markets Fool.com

It's mailbag time again on theRule Breaker Investingpodcast, and there are plenty of great questions forMotley Fool co-founder David Gardner. In this segment, a longtime listener wants to know why anyone would be interested in a negative-interest-rate bond.

Continue Reading Below

A transcript follows the video.

A secret billion-dollar stock opportunity
The world's biggest tech company forgot to show you something, but a few Wall Street analysts and the Fool didn't miss a beat: There's a small company that's powering their brand-new gadgets and the coming revolution in technology. And we think its stock price has nearly unlimited room to run for early in-the-know investors! To be one of them, just click here.

{%video%}

This podcast was recorded on July 27, 2016.

David Gardner: And the last one this month comes from my friend Frank DiPietro. Frank is a longtime Motley Fool member. I've met him at member events over the years. He's @frdip on Twitter. Frank, you wrote @RBIPodcast: "Why would anyone invest in a negative-interest-rate bond? I understand there are $12 trillion invested in these worldwide."

Continue Reading Below

Well, I've gotten a number of questions about these in recent Mailbags, and I keep kind of ducking it, because the negative-interest-rate world is not something I've studied or thought that much about. And I don't really know too much what to do with it, either, other than to point out that interest rates will ever go too negative, I don't think, because if they do, people will just start sitting on cash and not at all investing in these kinds of instruments.

So what's happened is that interest rates have gotten so low that when they decline a little bit below that, sometimes they can go below 0%. So technically what you're doing is you're giving your money away, and you're paying interest to whoever is keeping your money for you at your bank for them to do that. It's like you're taking out a self-storage unit, except it's for your cash, not for that old sofa that you still haven't given away after college.

So this is a really interesting phenomenon. As Frank points out, there's huge amounts of money that are sitting in things where you're paying a negative interest rate. That is, you're not getting paid. You're paying somebody to hold it.

Now, how has this even happened? It's primarily happened because central banks have set their interest rates extremely low. And what a central bank -- the dominant bank in a country; let's say the Fed in the United States of America -- what they're doing they're is saying to banks, "We're penalizing you if you try to put your money with us. We want you banks, you bankers, active in the world. We want you using Pokemon Go except with your money, not your iPhone. We want you investing your money. We want you loaning it out. We want you starting businesses. Don't just park your money. If you park your money with us, then you will have to pay us to do so. Wouldn't you rather loan your money and make more money doing that?"

And in the same way that a central bank is saying that to its domestic banking system, that's kind of what your local bank is saying to you and me as investors: "Rather than leave your money with us, where arguably you're getting paid almost nothing or might even have to pay us at some point to do that for you, why don't you go out and use your money?"

Now for a lot of us in Rule Breaker Investing, we're using our money in stocks. I think that's a lot better of a place to be, obviously, than in zero-interest-rate or negative-interest-rate things. And good companies that have enough money to pay dividends will have dividend yields, sometimes, of 2% or 3%. That's like the interest rate you and I are getting paid for just holding that stock, assuming that stock stays at its same price. Whether it goes up or down changes it a little bit. But the point is you can find pretty good interest rates just for holding good dividend stocks -- far better than you'll find from your banks.

So I think what our banks are saying to us is, "Go out and use your money. Let's get the velocity of money moving ahead again." A lot of this is still an overhang of the really horrible conditions of 2008-2009. And so, certainly, textbook cases will be written about what's happened here, now, in 2016, when substantial portions of the world -- of Europe, for example -- are operating with a negative interest rate. It's very rare for this to happen. But again, I don't think it's that sustainable. I'm not heavily worried about it. If it were to go more and more negative, no one will put their money with banks, and so it will not be sustainable for the banking system to do that.

But Frank, you're asking why do people do this, because they are doing it. And to try to answer the question briefly here, as we close, the answer is that traditionally, bonds are kind of an offset to the stock market. The reason some people think you should be diversified into bonds is because when stocks go down, bonds often don't. And so if you are a large asset manager, and you're trying to park lots of cash different ways and keep yourself safe and balanced, then you have appreciated having something that protects you in the one out of three years where the stock market loses value.

So you can see why, maybe, if you don't think the market's going to have a good year in the year ahead, if you think that one-third probability is popping up in the next 12 months, well, darn it, let's say the stock market goes down 13% over the next year. For you to have just paid 1% to somebody for your bond, which sounds crazy -- it was a negative interest rate, but you're in that bond instead of in stocks -- then net-net, you've saved yourself 12 percentage points of potentially lost capital.

So that's a reason, certainly, if it is $12 trillion, that a lot of that money is sitting in those things. And part of it is there's just so many assets, globally, that they can't all go just into the stock market. They need to be lots of different places, and there are all kinds of diversification schemes that people ask of their bankers or that asset managers have to obey anyway. So that explains some more of that money there.

I hope this brief meditation on negative interest rates has been a little bit helpful for you as you think through "Why would the world work that way, and what does it mean for me." But I'll admit that the world is very complex, and it's something I haven't read about that deeply, because I just stay invested in stocks as I have been the last 30 years, and as I plan to be the next 30 years.

Why don't we close it on that moment.

David Gardner has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Twitter. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.