Through the wardrobe, and into the endless white winter

THE NAVIGATION INN, STAFFORDSHIRE – “No interest? No problem!”

So cry investors as the Italian government beats them bloody with a brand new stick: the zero-coupon bond.

While it’s the first time the Italian government has been able to get away with it, the zero-coupon bond is a very simple form of debt. It’s pretty close to the kind of borrowing you’d find taking place behind the bins in a primary school playground: you give me 50p now, and I’ll give you a pound in, say, a week’s time.

There are no interest payments – “coupons” – being paid in between the borrowing and the repayment, which is what gives it the title “zero coupon”. The lender has to wait until the loan matures before they get anything back – no crumbs of interest in between.

The mechanism by which these loans are made is via auction. The government Treasury in question writes a promise to pay a fixed sum in several years’ time – say, €1,000,000 – on a document, and then puts that document – a “bond” – under the hammer. Investors then bid against each other to buy it.

The difference between the winning bid and the promised repayment is their prize: for example, if the winner pays €99,000 for a €100,000 repayment in a few years’ time, they’ll earn a yield of one per cent if all goes well.

This is standard fare for many governments borrowing over the short term, like a few months – those debts are called “bills”. But this is the first time the Italian government has managed to pull off a three-year loan of this type. Pretty impressive, considering their credit rating was downgraded in April to one notch above “junk”.

But here’s the best bit: guess what kind of repayment the folks who bought it are gonna get if they hold on to this bond until it matures…

Not 0.1%… Not 0.01%… Not even zero per cent, on a zero-coupon bond!

No, dear reader. These poor blighters waded into the auction… and paid a higher price for these zero-coupon bonds than the Italian government will pay them back in a few years’ time. To use the above example, they bid over €1 million today for the repayment of €1 million in three years. The yield they will earn for buying this asset will be negative: lending the Italian government money for three years will “reward” investors an incredible -0.14%.

I used to be able to half-understand the whole “negative yielding bond” thing. ‘Way I saw it, there are large investors out there who need interest payments so bad, and so often, that they’re willing to take a hit on the return on their bond investments. I’m talking about large pension funds and insurance companies who need to make constant and reliable payments of cash to retirees and insurance claimants. But in that scenario, the saving grace of these bonds was the interest payments – the coupons!

But now that Italy borrowed €3.75 billion yesterday using zero-coupon bonds… sold at negative yields… I’ll need to step further through the wardrobe and into Narnia to get a grip of what’s actually going on here. I’ll need to start entertaining some of the more imaginative, “out there” views on what could be really be driving this.

So what could drive a man to lend money to the Italians for less than nothing and without any interest payments on the way? Let’s have a wander through Narnia and see if we can find out.

“Have you seen this bond investor, Mr Tumnus?”

The mysterious bond investor whose motives we just don’t understand could really just love the Italian government I suppose, but you’d think such an “act of charity” would be made the “normal way” via political campaign contributions. So subsidising politicos out of the goodness of their heart is out. However, there is the possibility they are being forced to purchase the bonds for regulatory purposes (the government is forcing them to subsidise itself) which we shouldn’t rule out.

Next possibility, number #2: he’s a big market player in the eurozone with many zeros to his name, but he doesn’t trust the banks to keep his cash safe. This is pretty understandable given recent history, and given the state of all eurozone bank stocks.

Instead of parking his cash in a bank that could fail, he’s parking his cash in the government’s bank account, which is much less likely to run out. Possible… but then would you go with Italy? If you want a government with a reliable track record of paying its debts, you’d be better off in Vienna…

Possibility #3: he’s a banker. Buying a negative-yielding bond doesn’t matter if you can use it as a reserve asset to make loans, and charge interest on those loans that is greater than the negative yield on the bond. This is probably the sanest option in Narnia – but one has to wonder what kind of lending opportunities banks are finding in the eurozone right now in such an already indebted area.

Possibility #3.5: he’s a banker, and can afford to make loans to the government which pay him less than nothing, as he charges more than nothing to the poor bastards who have their cash on deposit at his bank. Abominable – yet possible. Make sure you’re never one of the poor bastards.

Possibility #4: he’s a degenerate river boat gambler. Buying the bond was a dumb idea, but there’s somebody dumber out there who will buy it off him for a higher price (like the European Central Bank). Of all the individuals and institutions now owning this zero-coupon negative-yielding bond, there’s gotta be one of these guys in there somewhere.

Possibility #5: it was never a man who was buying the bonds after all, but the Ice Queen herself – the White Witch. That’s right, I’m talking about a deflationista with a serious budget. If deflation arrives in the eurozone and the prices of all or most assets fall in euros, eurozone government bonds might be a good trade if you’re confident they won’t be defaulted upon.

Negative yields don’t matter if the currency you’re being paid has increased in purchasing power to a greater degree. But then why buy the bonds, and not just hold the euros in a bank account? See option #2 – deflation kills banks, so you might not want to trust them with billions of euros in when its cold grip drags them under.

And lastly, possibility #5.5 – the Ice Queen, but with a twist. What if we have encountered a market beast rarer, as precious metals expert Ronnie Stoeferle would say, “than a good song on a Britney Spears album”?

Yes, dear reader: what if we have encountered an investor… who is bullish on the euro? The negative yield they’re paying doesn’t matter to them – because the value of all the other currencies will fall against the euro at a greater rate. A rare breed indeed – there’s almost certainly more of those in Narnia than on our side of the wardrobe.

These are the possibilities I can think of which would drive somebody to buy – if you can think of any others, do let me know: [email protected].

I can’t say I fancy lending my money to the Italian government for less than nothing for three years – I think I’ll leave that to the Narnians and head back to reality.

Aslan did say he’s known by another name on our side of the wardrobe. I reckon its “Aurum”.

Until tomorrow,

Boaz Shoshan
Editor, Capital & Conflict

Category: Central Banks

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