There is a story on CBC that investors are lining up to buy bonds with negative return from Canadian Imperial Bank of Commerce (CIBC). I don't understand why they are doing so.
Can someone explain why it makes sense to buy CIBC bonds with negative return?
Why would that be preferable to holding the amount in cash?
First note that CIBC issued these bonds with a zero coupon, so they do not pay any interest. They were purchased by the market participants at a small premium, paying an average of 100.054 for a nominal value of 100. This equates to a negative annual "redemption" yield of 0.009% - i.e., if held until maturity, then the holder will witness a negative annual return of 0.009%.
You ask "why does this make sense?". Clearly it makes no sense for a private individual to purchase these bonds since they will be better off simply holding cash. To understand why there is a demand for these bonds we need to look elsewhere.
The European bond market is currently suffering a dwindling supply owing to the ECBs bond buying programme (i.e., quantitative easing). The ECB is purchasing EUR 80 billion per month of Eurozone sovereign debt. This means that the quantity of high grade bonds available for purchase is shrinking fast.
Against this backdrop we have all of those European institutions and financial corporations who are legally obliged to purchase bonds to be held as assets against their obligations. These are mostly national and private pension funds as well as insurance companies and fund managers.
In this sort of environment, the price of high quality bonds is quickly bid up to the point where we see negative yields. In this environment companies like CIBC can borrow by issuing bonds with a zero coupon and the market is willing to pay a small premium over their nominal value.
TL/DR
The situation is further complicated by the subdued inflation outlook for the Eurozone, with a very real possibility of deflation. Should a prolonged period of deflation materialise, then negative redemption yield bonds may provide a positive real return.
Historically, most economists considered a sustained negative interest rate impossible for just the reason you describe: an investor could outperform a bond with a negative interest rate by simply hoarding cash. For background, see Wikipedia. Experimentation by central banks in the wake of the 2007 financial crisis, however, demonstrates that slightly negative interest rates are possible.
First of all, note that the "zero lower bound" on interest rates has everything to do with the existence of cash as an alternative. It's a lower bound on the nominal interest rate, rather than the real interest rate—that is, on the rate before adjusting for inflation. In most situations, the real interest rate is more economically meaningful, as it's the real interest rate that measures the market's preference for "stuff now" as opposed to "stuff later." There's nothing in principle or in practice to stop a negative real interest rate: there are always some people who want stuff now and some people who want stuff later; a negative real interest rate just means that people who want stuff later are more dominant in the market.
As I stated earlier, what creates the "zero lower bound" is the existence of cash as an alternative to bonds. Even though that lower bound applies, it's not strict: hoarding cash in large quantities can be difficult and expensive, especially when central banks are doing their best to prevent you from doing it. Consequently, investors who strongly prefer "stuff later" to "stuff now" are willing to pay a slightly negative nominal interest rate on bonds in order to avoid those costs. If it were significantly negative, however, you're right that no sane investor would buy such a bond.
There is another reason why an investor might buy negative yielding bonds: if the investor expects that bond yields will go even further negative, then they are also expecting the price of the bond to go up. They can resell the bond later at a profit.
As an example, they may expect an increase in central bank bond purchases to drive yields lower and prices higher.
Fundamentally, it's no different than normal. A risky entity must entice investors with higher interest rates than less risky entities. We're just in such a low interest rate environment that the rate spread now dips below zero and very low risk entities can issue debt with a negative coupon.
Though I agree that this makes no sense and the world's gone mad.
There is some sense that negative interest rates make no sense, because then two things appear to happen
Neither of these are true in reality. But then we are edging towards a deflationary time, during which the common understanding of money and what to do with money reverses. During deflation, spending is better (to an extent) because the buying power of money is less as time passes, so also saving is less worthwhile.
But for the bond market (and your question), the reason why people are still investing in negative interest bonds, is that they are going to be looking to capital gain to make their money. Over time the bond price fluctuates and as the bond approaches maturity, the bond price equates to the face value minus whatever interest will be received, or in this plus whatever interest will need to be payed.
