Why Would Anyone Buy A Negative Interest Bearing Bond?

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Includes: DFVL, DFVS, DTYL, DTYS, GSY, IEF, IEI, ITE, PST, SCHR, TBX, TBZ, TYD, TYNS, TYO, UST, VGIT
by: Cullen Roche

Good question here from the Q&A section about negative yielding bonds:

Hi Cullen. The Economist had a good article explaining why people buy negative yielding bonds.

http://www.economist.com/blogs/economist-explains/2016/02/economist-explains-6

Do you agree with their explanation?

The Economist's explanation is a bit odd as it leaves out the main reason that someone might want to buy a negative yielding bond - the fact that they expect it to appreciate in price thereby offsetting the loss in yield. For instance, let's do a little bond math:

If we have a 10-year bond yielding 0.01% and this bond declines to -0.5% over the next 12 months, then I will make about 5.25% in capital appreciation. That's:

[(0.01% X (1-(1-0.5%)^(-10)) ÷ -0.5%+1 ÷ (1-0.5%)^10)-1]+0.01%

I think I wrote that correctly. Anyhow, in this case the bond buyer has purchased a 0.01% 10-year bond and has seen a 5.25% appreciation in the price because the yield has fallen even further. If I pocket the cap gain and someone buys my bond at -0.5% and it falls to -1%, then the bond will appreciate another 4.8%. In other words, the purchaser of a negative yielding bond is betting on deflation and even lower rates. It's not a whole lot more complex than that if you ask me.

Of course, in the long run, the issuer of the bond will get their negative yield. In this sense, negative interest rates are a tax on the private sector as they directly remove interest income. I am still baffled as to why any economist thinks this is a good idea. We are venturing into theoretical territory that is very dangerous in my opinion.