Nearly a third of the global sovereign debt market carries a negative yield. Most, but not all, is in Europe. When yields are negative, bondholders do not receive a coupon payment, but pay to own these bonds. This unique environment prompts several important questions.

What causes negative bond yields? Why purchase a bond with a negative yield? Do negative yields portend an ominous future? To help answer these and other questions, I spoke with Strider Elass, Senior Economist with First Trust Portfolios L.P.

Mike Patton: What caused bond yields to turn negative?

Strider Elass: It may be traced to the negative interest rate policies adopted by various central banks. Additionally, in the post-2008 crisis world, many countries believed the way to fix their economies is by lowering rates even further to jump start investment and essentially force banks to lend, yet most of these economies continue to struggle. What ails these economies is not a lack of money, but poor fiscal policies, including high taxes, over-regulation, and high government spending. Yet, nothing is being addressed on the fiscal side. I believe Denmark was the first country to go negative (2012). Much of the rest of Europe followed suite in 2014. Japan’s bond yields turned negative the same year.

Mike: Why would anyone purchase bonds with a negative yield since there is no regular coupon payment?

Strider: It baffles me. Since there is no regular coupon payment, the investor can only make money if the price rises above what they paid for the bond. If investors believe economic conditions will deteriorate further, they will invest more money in these “safe” securities and prices will rise further. This would also cause yields to become more negative. In Europe, knowing the ECB will continue to buy, gives many the idea there is a backstop.

Mike: Since bond prices have risen substantially, is this a bond bubble and if so, what might happen when it bursts?

Strider: Yes, I believe this is a bubble. At some point, when the EU economy recovers, optimism will return. This will likely prompt bond owners to sell and invest in risk assets. Like past bubbles, when it bursts, prices will fall rather quickly (and yields will rise). Investors who are holding these bonds when the bubble bursts will experience a good bit of pain. This could cause the government to step in to alleviate the pain. While we don’t know what specific policies the EU will implement, whatever they do will cost money, making it necessary to issue more bonds. It’s hard to say how this will end.

Mike: How do negative yields affect the government’s that issue this debt?

Strider: This is a benefit for government. For example, assume Country A issues $1 million in debt priced at a premium of $110. The investor pays $1.1 million to purchase it. At maturity, the investor (or whoever holds the bond at that time) will receive par (100) or $1 million. Hence, the government is guaranteed a profit of $100,000 or 10%. Also, low and negative yields make the cost of borrowing very cheap.

Thank you, Strider.

Clearly this is a unique environment as sovereign bond yields remain negative. How it will end is difficult to say. However, this negative rate environment is clearly distorting the fixed income market. In addition, the road to yield (and price) normalization will bring some degree of pain to bondholders. It’s a bit like the game, hot potato. If bond prices rise further, their yield-to-maturity will continue to deteriorate. I wouldn’t want to be caught holding these securities when they mature.