Markets

Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets. She has written about debt markets for Bloomberg News since 2010.

For those who doubt that negative interest rates are bad for banks, take a look at what's going on in Japan.

The nation's commercial lenders are loading up on bonds that don't come due for decades to get some yield, any kind at all. They bought a net 197.4 billion yen ($1.7 billion) of superlong Japanese government bonds in January, up from 7 billion yen the month before, according to a Bloomberg News article by Chikako Mogi and Shigeki Nozawa.

The banks are in a bind because bonds with maturities extending out a decade all carry negative yields as a result of the Bank of Japan's attempts to suppress borrowing costs, including its January announcement to charge interest on some bank reserves. So unless financial institutions want to own bonds that pay them nothing, they need to lend for much, much longer or take on more credit risk.

Goodbye Yield
Investors are now paying Japan to borrow for 10 years in the wake of the nation's stimulus efforts.
Source: Bloomberg

The outcome could be scary. If Japan's stimulus efforts actually work, and inflation picks up, benchmark borrowing costs will rise. These banks will end up feeling a whole lot of pain, potentially causing a shock, or at least a big tremor, to the nation's financial system.

That's just Japan. Now let's shift to Europe, where German 5-year bonds reached a record low of negative 0.4 percent on Monday. The environment has prompted banks and institutions alike to accept lower premiums to own riskier securities.

"Some banks are overextending credit at conditions that in my view may also create future potential of risks in the system," UBS Chief Executive Officer Sergio Ermotti said on Bloomberg TV on Wednesday. "There are banks that don’t know what to do any longer with deposits, so everybody is trying to beat each other on pricing, and eventually this is going to lead into a structural deficit.''

On the one hand, you can't really blame financial institutions for reaching a little bit. High-yield bonds in Europe, for example, yield about 6 percentage points over benchmarks right now. That looks pretty great when faced with assets that pay no income at all.

Paying to Lend
The volume of negative-yielding debt is swelling, with some German yields plunging to fresh lows.
Source: Bloomberg

But on the other, riskier bonds carry bigger premiums for a reason: They're risky. U.S. junk-bond buyers have spent the past nine months licking their wounds as the debt lost an estimated $120 billion of market value, based on Bank of America Merrill Lynch index data. And ultimately, the greatest risk may lie in stockpiles of the safest securities, government bonds that are carrying such incredibly low yields. Longer-dated bonds are much more vulnerable than shorter-dated ones to big losses should benchmark yields start increasing.

So while the jury is still out on whether negative rates will help ignite inflation, some of the recent evidence suggests that they are impairing the strength of the financial system.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Lisa Abramowicz in New York at labramowicz@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net