Uni.lu Prof Koulischer: Luxembourg's AAA Investment Ratings Keep Negative Government Bond Yields Attractive

Chronicle.lu recently got the opportunity to speak with Prof François Koulischer, Assistant Professor in Sustainable Finance at the University of Luxembourg, to discuss negative government bond yields and their impact in the world of finance.

Prof Koulischer's research interests include financial intermediation, applied macroeconomics and sustainable finance. Before joining the University of Luxembourg, he was an economist at the Central Bank of Luxembourg (Banque centrale du Luxembourg – BCL) and the Bank of France (Banque de France). At the University of Luxembourg, he teaches Banking Theory, Econometrics and Empirical Methods.

Negative bond yields are a general topic of interest and, according to the latest data from European statistics agency Eurostat, particularly from Luxembourg's perspective, which recorded the second highest negative bond yields in the Euro area in 2021 at -0.36% – just shy of -0.37% in Germany.

In economic terms, negative bond yields mean that investors would pay the government to hold their debt, which may seem paradoxical. Chronicle.lu reached out to Prof Koulischer for an explanation on how negative bond yields function and what implications they have from a consumer's perspective.

Chronicle.lu: Why and how do negative yields on government bonds happen? What are the associated risks for investors and why do they still do it?

Prof Koulischer: I guess the best way to introduce negative bond yields is to start with the concept of the zero lower bound (ZLB). The ZLB hypothesis states that interest rates can never be negative because of the existence of cash. If interest rates, for example on your bank account, would be negative, then there is always the possibility to hold cash which provides a 0% return.

In practice of course, things are more complicated. Holding cash is expensive in a variety of ways: for large amounts, it raises important security costs and it may not be possible to withdraw very large amounts of cash. Economists and policymakers therefore prefer to mention the "effective lower bound" (ELB): interest rates can become negative, but the more negative they become the higher the incentives to hold cash, which induces distortions in the economy.

The ZLB and ELB are important constraints faced by central banks when implementing monetary policy when interest rates are low. In general, central banks reduce their interest rates by 4% to 5% when a recession hits. If interest rates are low to begin with, however, they are unable to lower their interest rates to stimulate the economy in case of recession.

To overcome this constraint, central banks have resorted to a number of policies, including negative interest rate policies. The European Central Bank (ECB) has for instance lowered the interest rate on its deposit facility to negative 0.5%. In doing so, the ECB considered that the cost of distortions caused by negative rates were lower than the benefits of increased stimulus. The ECB did so in response to a general environment of low inflation in the aftermath of the 2012 sovereign debt crisis.

This policy was then transmitted to other asset classes, including government bonds such as the Luxembourgish debt.

[As] for why investors will still do it, sometimes there is no alternative and other assets may offer higher returns but also carry higher risks.

Chronicle.lu: With the ECB's €1.85 trillion pandemic emergency purchase programme (PEPP) expiring in March 2022, how will this impact bond yields in the euro area in the second half of 2022?

Prof Koulischer: Stopping the net asset purchases by the ECB will reduce the accommodative stance of monetary policy and could therefore, all else equal, increase interest rates.

Chronicle.lu: The consumer price index in Luxembourg show continued inflationary pressure, a sign of healthy economy, leading to two automatic wage indexations (Jan 2020 and Oct 2021) and the AAA investment ratings are confirmed in 2020 as well as in 2021. Why then are the government bonds still negative?

Prof Koulischer: The AAA rating reflect the low risk of Luxembourgish debt. As the stock of low-risk AAA assets is limited in the Euro area, these securities are in high demand which could also explain the negative interest rates.

The automatic wage indexations could become a risk to Luxembourgish debt if this affected the competitiveness of the Luxembourgish economy, in turn increasing the risk of the government.

Chronicle.lu: More recently, fuel and housing prices are the major contributors of inflationary pressure in Luxembourg. How do you think these two factors will evolve and influence the government bond yields?

Prof Koulischer: The future behaviour of inflation is one of the key policy unknowns at the moment. The pandemic has changed many features of the economy, but it is also not fully clear how permanent these changes will be. The question of whether shocks are permanent or transitory is important to shape the response of central banks as monetary policy must respond to permanent shocks in order to anchor inflation expectations. If the increase in house or energy prices were to spread to other sectors of the economy and shift inflation expectations, the central bank would have to tighten its policy. This would increase bond yields.

Chronicle.lu: The saving accounts in Luxembourg have nearly zero interest rates in 2021 and while this increases the pressure on households to invest in risky assets, how does it affect government bond yields?

Prof Koulischer: Lower interest rates on saving accounts, all else equal, increase the incentive of households to invest in other assets. This could reduce government bond yields. Note that, as for the stock market, government bond yields respond to a host of factors of which deposit rates are only one determinant and government bond yields could also influence deposit rates in return.