Why Buying Bonds With Negative Yield Isn’t as Weird as It Sounds

NEW YORK (MainStreet) — Germany had a historic moment last week, for the first time selling five-year government bonds with a negative yield. Buy these securities paying minus 0.08% and you would end up with less than you started with, an investing strategy that seems, well, upside down.

Why would anyone buy such things? And what does this spotlight on today's low-interest environment mean for ordinary folk trying to safeguard a rainy-day fund or store cash while awaiting an investment opportunity or big purchase?

While a first for Germany, other countries have sold negative yield bonds from time to time. Investors with too much money to keep under a mattress buy such bonds because they're willing to pay a little something for the safety of a government-issued security. Also, there's a chance that what's lost in negative yield can be made up if changing conditions nudge the bond's price upward. If newer bonds had an even bigger negative yield, for instance, demand for older ones might rise, pushing up the price.

To be picky about it, many ordinary investors and savers have effectively lived with negative yields for years, because minuscule savings on bank deposits and money market funds have been more than wiped out by inflation - even though inflation has been low too.

The German bond sale, and recent comments from the Federal Reserve in the U.S., indicate that low interest rates will persist. So what should ordinary savers do with their cash?

An article in The Wall Street Journal points to a few alternatives such as short-term bond funds or corporate funds that buy higher-yielding bonds with more risk, perhaps boosting yield by a percentage point. But that's such a small gain it hardly seems worth the trouble, especially if it comes with the risk of losing principal.

So here's an alternative: Keep less cash, putting more money into long-term holdings such as stock funds. This may require a new approach to needs traditionally served by bank savings and money markets.

Everyone, for example, needs a rainy-day fund, which should probably be enough to cover six to 12 months' expenses. Bank savings should continue to make up a big chunk of the emergency fund, because safety and easy access are so important. But you can trim the fund if you establish other resources to make up the difference in a crisis, such as a home equity loan or reverse mortgage, both of which can be taken as a line of credit to be used only when necessary.

Also, by taking steps to improve your credit rating, you may be able to reduce the rates on your credit cards and raise your credit limit, which lets you borrow easily during a rough patch. So correct any mistakes on your credit report, pay down debt and be sure to pay bills on time.

Thrift works too. The less you spend, the less you need in your rainy-day fund. Most important is to avoid big commitments, such as a large mortgage or loan on a pricy car, that can't be quickly cut if money is tight.

Many people set cash aside for a big expense. For some, such as college costs coming soon, cash is still king. But other expenses, including down payments on a home or cash for a new car, can often be postponed if necessary. Cash for those purposes could be pulled from investments such as stocks and stock funds, with the purchase delayed if it's a bad time to sell.

Cash is also used as "dry powder" - held in reserve until a promising investment comes along. But most investors aren't very good at timing the market. So rather than keeping a large cash hoard, you could use a dollar-cost-averaging strategy of simply investing a set sum each month. Stretching the investment over six months or a year will be less risky than going all in at what could turn out to be a market peak. And dollar cost averaging is a lot less stressful because you don't have to second-guess your timing.

So, yes, yields on cash are about as stingy as they've ever been. But that doesn't matter so much of you cut your cash reserve to the minimum.

— Written by Jeff Brown for MainStreet

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