Government bonds are often labelled as risk-free investments and are favourite financial instruments among fixed income fund managers.
Government bonds are IOUs issued by the government and the government pays interest rates on its IOUs just like bank loans. However, some government bonds are sauntering into negative yields these few months. What does this negative yield mean? It means consumers have to pay interest rates to the government for buying the bonds. In other words, you pay interest rates for lending money to someone instead of collecting interest rates for money lent out. Many people cannot reconcile this negative bond yield with the traditional bank loan concept that is imbued in them.
Thus, why would fund managers be interested in these negative bond yields? Surely, they have the financial literacy to know this is a money losing investment. Well, fund managers know something that ordinary people don't. Fund managers can perform the midas of turning negative yield into positive yield. How is this possible?
Let's suss out the MIDAS!
Fixed income fund managers will sift out arbitrage opportunities in other interest rates related financial derivatives as a trade off to the negative bond yields by doing interest rate swaps in different currencies.
Example of USD-Yen interest rates swap:
A USD fund manager will borrow yen and lend out USD using Libor rates.
Facts:
3-month USD Libor : 0.82%
3-month JPY Libor : -0.02%
USD-Yen interest rate swap spread: 0.64%
3-month JPY Bond yield: -0.24%
When a USD fund manager borrows yen, he will pay JPY Libor (-0.02%) and receive USD Libor (0.82%) for lending out USD with a spread of 0.64%. Since the JPY Libor is a negative rate, the USD fund manager will receive interest of 0.02% instead of paying 0.02% interest.
Therefore, the net effect in carrying out this USD-Yen interest rates swap is 0.82% - (-0.02%) + 0.64% = 1.48%
Then the fund manager will invest in JPY bonds with -0.24 yield with the borrowed yen which means the net effect is 1.48% - 0.24% = 1.24% because he has to pay an interest rate to the government instead. As you can see, the smart USD fund manager has managed to earn 1.24% instead of 0.82% when he invests only in USD Libor.
Since China has the largest USD foreign reserves, it has performed the USD-Yen interest rate swap and bought a lot of negative JPY bond yields these few months.
