'Less than Zero': Japan's negative yield bond explained

TOKYO - The yield on Japan's benchmark 10-year government bond dipped below zero for the first time this week, offering the topsy-turvy promise of investors paying to lend someone money.

What are bonds?

Sovereign bonds are a way for governments to raise cash for their spending plans, promising lenders (investors) a guaranteed income - or yield - per year.

Like any other loan, borrowers usually have to pay interest on the money, and have to pay back the capital at the end of a fixed period.

Nearly all countries issue these bonds and - like other loans - the amount they pay generally depends on how risky lenders believe they are. If a lender thinks his money is very safe, he won't charge much interest; conversely, if he's worried the loan will go bad, he'll charge a lot.

The United States pays about 1.7 per cent, Germany pays around 0.2 per cent and hard-hit Greece must pay about 10 per cent on its decade-long notes to attract wary investors.

But Japan's yield is now negative?

That's right, meaning anyone buying a bond (becoming a lender) has to pay for it.

For example, if an investor was to hand the government ¥100,000 (US$875 or S$1,216) for a 10-year bond at Tuesday's -0.035 per cent rate, it would actually cost him ¥3,500 (S$43), so he would only get back ¥96,500.

Why on earth would anyone do that?

For the man in the street, the answer is that they wouldn't. They would be much better off stuffing their cash under the mattress.

But Japan's government bonds are overwhelmingly held by institutions like banks and insurers rather than mom and pop investors.

And they would need a lot of mattresses to hide the cash they're sitting on.

Bonds are generally seen as super safe investments where capital is all but guaranteed, even if they pay very little - or no - interest. This means they become very sought after during times of economic crisis such as that currently roiling global markets.

And in any case, the options for Japanese banks are limited - the Bank of Japan (BoJ) has already reduced its benchmark interest rate to -0.1 per cent, so keeping cash in its vaults is expensive, and -0.035 per cent seems like quite a good deal.

What will happen next?

The benchmark 10-year bond crept back into positive territory on Wednesday but could head south again.

But the BoJ's negative interest rate has so far failed to have the desired effect of forcing banks to spend their cash, and some analysts suspect the central bank could push the rate even lower; that, in turn, could squeeze bond rates further.

However, the BoJ is the middle of a vast bond-buying scheme as part of a plan to stimulate the economy, so banks and insurance companies might want to gamble on the idea that the central bank will expand this plan

That means if they buy below-zero yield bonds now and sell them back to the BoJ at a later date when yields have gone up, they will make money.