Faced with a challenging macroeconomic environment, several central banks around the world have embarked on unconventional campaigns to provide monetary stimulus by moving their policy rates into negative territory. The policy rate is the rate at which domestic banks can borrow from their respective country’s central bank. Although their motivations and implementations may slightly differ, the European Central Bank (ECB), the Bank of Japan, and the central banks of Switzerland, Sweden, and Denmark have implemented a negative interest rate policy (NIRP).
Central banks are not the only players in global bond markets. Governments, banks, and companies all around the world have different needs that may cause them to issue and invest in bonds. Individual investors may also hold fixed income, either with direct bond holdings or through vehicles like mutual funds and ETFs. The collective supply and demand of all these market players determines the yields on investment securities. These market forces have pushed the yields on short-term securities in Japan, Germany, Switzerland, Sweden, and Denmark into negative territory. In fact, the market yields on these short-term bonds were negative before their central banks set their policy rates below zero.
For a US investor, bonds in foreign markets with negative yields may still provide positive expected returns if the currency exposure is hedged back to US dollars. Although typically viewed as a tool for controlling volatility, currency hedging may also transform a negative yield into a positive yield for some bonds, thereby enhancing expected returns. The hypothetical example in Exhibit 1 shows how by hedging the foreign yield curve to the local yield curve’s currency, the foreign yield curve’s short-term interest rate shifts to the local yield curve’s short-term interest rate.