What Is Inverted Finance & The Time Value Of $?O
If I asked you for a $100 and only repaid you $95, would you transact with me? Of course not, as I suspect that most monkeys here have gone through at least one course in corporate finance. However, some people would. I present to you a case in real finance, the German 2-year, the Swiss 5-year, and even back in 2009, the U.S. 3-month bonds all traded with a negative rate of return...and investors were buying them! But why would any rational person invest in a negative return? Two concepts: yield-price relationship and risk premium, read more to find out how they work…
One of money’s characteristics is a store of value which means that one can forgo spending today and expect a stable value in future expenditures. When you invest your money there is an opportunity cost to that decision and as compensation, an interest rate is paid in addition to the principle reflecting the time-value of the invested money you could have spent otherwise. When calculating a return for this time-value, a positive interest rate is always used as its assumed investors are rational and wouldn’t make a certain losing investment. For example,
...the future value of a $1000 U.S. 3-month bond yielding 1% with a coupon of $10 is $1060.60 which is greater than its par value, a rational decision. But, if we invested at -1%, the future value then becomes $940.60 which is less than par, a certain loss."
Yet, European investors were choosing the latter option, so how does this happen?
There is an inverse relationship where rising demand increases the bid price of bonds as the supply of loanable funds from investors shifts rightward thus, reducing interest rates. Simply put, by bidding up the demand for German bunds it drives interest rates down. The result, is shown as a shift in the German yield curve in July (green) from the month prior (yellow). Timeliness is not of importance but rather the information, note how the curve has shifted downward and look at the shorter-term maturities.
click here to enlarge
Here’s another graph, specifically the 2-year bund and you can clearly see the negative interest rates plotted by James Mackintosh of the Financial Times.
click here to enlarge
Why would a rational person invest with a negative return?
The risk-premium, or rate of return in excess of a riskless return, can help explain this behavior. A bottoming-out of the yield for short-term maturities indicates that capital outflows are leaving longer-term ones and going into the likes of the 2-year which has caused a distortion in the yield curve. This is indicative of excessive demand for very liquid, risk-adverse assets and a flight from the longer maturities whose risk-premiums are inadequate to compensate for the time-value of money and the probability of loss.
Primarily, I suspect that the German bunds are perceived as a safe haven, like the Franc in the currency market. Secondarily, there has been a absence of investment opportunities due to the austerity measures and lackluster economic growth. Lastly, there is an ebb and flow of the probability of denomination risk or the possibility of an all out exit among the PIIGS.
That’s my perspective but voice your opinion and let us know…what’s your analysis on these negative interest rates and what do you think it signals?