Why Would Anybody Pay to Loan Money?

April 8, 2015 Updated: April 24, 2016    

Have you ever taken out a loan and the bank offered to pay you interest on it? The chances of that happening to an individual are slim to none, but some European countries are pulling off exactly that.

Switzerland for example just borrowed money for 10 years from institutional investors for a negative 0.055 percent. This means that every year investors pay Switzerland one-twentieth of a percent to enjoy the honor of holding its debt. Germany and Denmark are other countries whose bonds sometimes trade at negative yields. Why?

Yield of the Swiss 10-Year Bond:

source: tradingeconomics.com

First, it’s about deflation, or the phenomenon of falling prices.  

Even if you pay 1 percent to LEND money every year, you make money in real terms if prices fall by more than 1 percent on average. If you lend 100 and get back 99 but you can buy goods worth 105 previously, you are better off.

However, while deflation is a problem according to official statistics (consumer prices fell 0.9 percent in March), anybody having visited Switzerland will find the opposite to be true: Everything is really expensive and even local residents feel more like prices are rising and not falling.

So what’s the other reason institutional investors like banks, pension funds, and insurance companies are paying for the privilege to lend money?

In simple terms, it’s rules and regulations. When investing in fixed income markets many institutions face the requirement to invest only in AAA rated securities and there aren’t that many left. Only Australia, Canada, Denmark, Germany, Luxembourg, Norway, Singapore, Sweden, and Switzerland are rated AAA by all three big rating agencies (Moody’s, S&P, Fitch).

In addition, these countries are not issuing a lot of debt—that’s the reason, they are rated AAA, unlike Greece for example—so there is not much capacity to soak up all the liquidity in the market.

In addition to the rating requirement, there are a host of other internal and external factors like collateral rules that practically force investors to buy say German or Swiss bonds, even at negative yields. None of these factors require the investors to actually make a profit, which is rather odd.

However, given that the institutions are investing on behalf of their clients, it’s not their money to lose. As long as they can charge a positive management fee, they are happy locking in negative returns for their investors.