What does a negative bond yield mean?
When investors buy bonds, they are essentially lending money to bond issuers. In return, bond issuers agree to pay investors interest over the life of the bond and repay the face value at maturity. The money that investors earn from interest is called a return. Many times this return is positive, but there are certain circumstances where the return can also be negative.
Understanding the negative yield on bonds
If a bond has a negative yield, it means that the holder of the bond is losing money on the investment, although this is a rare event. Whether a bond has a negative yield depends largely on the type of yield calculated. Depending on the purposes of the calculation, a bond’s yield can be determined using the current yield or yield to maturity (YTM) formulas.
The current yield on a bond is a simple formula used to determine the amount of interest paid annually compared to the current selling price. To calculate, just divide the annual coupon payment by the bond’s sale price.
For example, suppose a $ 1,000 bond has a seven percent coupon rate, which means the bond pays $ 70 in interest per year and is currently selling for $ 700. The current yield would be 10% ($ 70 / $ 700 x 100).
Using this formula, it is almost impossible for a bond to have a negative return. Even if the price is significantly above par, a bond that pays interest will still have a positive current yield. For a bond to have a negative current yield, it must pay negative interest.
Calculating the YTM is a more comprehensive return formula because it incorporates the financial impact of the bond’s sale price and face value. The face value of a bond is the amount that the issuing entity must pay to the holder of the bond when due. The YTM of a bond therefore represents the rate of return an investor can expect if the bond is held to maturity.
Since the YTM calculation incorporates the payment at maturity, the bond must generate a negative total return to have a negative return. For the YTM to be negative, a premium bond must sell for so much above par that all of its future coupon payments might not be enough to outweigh the initial investment. For example, the bond in the example above has a YTM of 16.207%. If he sold for $ 1,650 instead, his YTM turns negative and drops to -4.354%.