Question

Not long after the United Kingdom’s vote to leave the European Union, the yields on some British Government bonds (called gilts) turned negative. Assuming that these bonds were issued with a positive coupon rate, would you expect their market prices to be above, below or equal to their face value? Explain your choice.

Answer 1

When Britain decided to leave European Union in june 2016, the 1 Year Bond yield curve falls below in zero percent in december 2016 to around lowest at -0.033%. This means that investor have to pay at maturity to hold that security if it buys at this Negative yield. The reason for this short term yield curve to fall below the zero level, was that the britain economy will enter in deep recession (if it moves out of European Single Market) and Bank of England will cut interest rates to support economy.

As bond price and bond yield shares inverse relationship, the bond prices rose and yield fall. This means that the bond was trading at premium to its face value. The other reason for fall in bond yield was investors expectations about the future. When the investor future inflation and growth expectations falls, the investor moves there capital to safer assets like UK bonds and sell riskier assets like equity shares, commodities and real estate. This leads to excess demand for bonds and thus fall in yield curve.

For example, suppose a bond having face value of 100 GBP giving return of 2% in 1 year. when market expects that  short term interest rate will fall and economy may enter in recession . The investors will move there capital to safer assets like bonds. Now if bond is trading now 103 GBP (premium) due to low rates and investor buys it, then it means that the bond is yielding negative return if investor hold the bond till maturity.

So, Yield to Maturity= (Face Value/Current Bond Price) ^ (1/Years to Maturity) −1

= (102 / 103) ^1/1 - 1

= 0.99029126213592233009708737864078 - 1

= -0.00970873786407766990291262135922

= -0.97 %

= - 0.97 % yield