How to make money on negative yieldsJanuary 12, 2012: 10:29 AM ET
German bonds yields are below zero, but it may not be so crazy to pay for the privilege of loaning a country money.
FORTUNE – Would you pay someone to give them a loan? That's essentially what's happening in Germany right now -- German short-term bills turned negative earlier this week, meaning investors will not only forgo returns on German debt, they'll actually end up with less money when the bonds expire.
It may sound preposterous, but that's not the only way of looking at it. Aside from finding a safe place to invest amid all the uncertainties attached with Europe's ongoing debt crisis, it's possible that investors can also make money on negative yields.
In an auction Monday, Germany sold $4.96 billion of six-month bills with an average yield of negative 0.0122%. This is reportedly the first time yields turned negative at a German debt auction. However, as The Wall Street Journal points out, short-term U.S. Treasury yields spiraled to negative territory during the worst of the financial crisis several years ago. With all the uncertainties in the market, investors pulled cash out of risky investments and put them into safer securities – notably, short-term U.S. government debt.
Investors typically expect to be repaid more than they lend. And indeed, Monday's auction in Germany signals they may be willing to settle for slightly less given fears about potentially big losses elsewhere. But it's possible for investors to gain more than expected.
For one, the price for these bills could rise if yields, which move in the opposite direction, fall further should the crisis in Europe take a turn for the worse.
And investors stand to see modestly bigger returns if deflation arises – a development some aren't ruling that out given expectations that Europe could slip into recession this year. When prices fall for a prolonged period, investors are better off stuffing cash under the mattress or a safe deposit box. Needless to say, corporations and money managers – discouraged from investing and lending given Europe's ongoing debt crisis – can't practically do that. So they flock to safety in bills and hope for better gains.
University of Miami finance professor Brian Barrett sees it this way: Say the yield on a short-term government bond is negative 0.5%. The bill pays $1,000 when it matures at the end of the year. So the price of the bill would be $1,005.
Now let's say copy paper at the start of the year is going for $10 a case. With $1,005, a company can buy 100.50 cases.
But let's say the company holds off and stuffs its money under a mattress. And at the end of the year, prices have steadily declined. Inflation has dropped to negative 1%, which means a case of paper is now going for $9.90. Now the company pulls out its $1,005 and can buy 101.52 cases. That's better than at the beginning of the year.
Obviously companies can't store money under a mattress. Executives need to put cash on hand at work, so they do what's essentially the equivalent. The investor, looking for a low-risk place to invest the company's cash, buys bonds at negative yields. By investing $1,005 in the bond, the investor ends up with $1,000 when it matures at the end of the year. With that, the company can buy 101.01 cases of copy paper. That's still more than it could buy at the beginning of the year.
So while it may seem investors are doing Germany a favor, in the end, the bigger winners are likely the investors themselves.