Why Invest When You're Guaranteed To Lose Money?

TraderPeople invest because they want to make money. Surely, no-one in their right mind would invest in anything that guarantees they will make a loss? Even in high-risk ventures where the most likely outcome is a loss, there is always the possibility of a big upside. It's like betting on a 20-1 long shot -- you'll probably lose but, if you do win, the payout is a whopping 2,000% return on your stake.

Last week saw buyers of new German government bonds accept a guaranteed loss, when an auction of €3.9 billion worth of six-month bonds was completed at a negative interest rate. These investors paid 0.0122% to the German federal government for the privilege of lending it money, but there are good reasons as to why they were prepared take the loss.

How these auctions work

In this type of auction, the price of the bonds is set at a discount to their redemption price and the interest that is paid is equal to the difference between the two prices. Typically, investors state the price that they are prepared to pay (or a required yield) and the amount they want to invest, and bonds are issued at the lowest yield that raises the desired amount of money.

These bonds were sold at a premium to their redemption price, guaranteeing that their buyers will lose money. So why were they so eager to buy them?

Fear trumps everything

Most people would not put £200 on deposit with their local bank if they were charged 1% a year for the privilege. They'd keep the money at home. But if you're dealing with hundreds of millions, there isn't a mattress big enough for you to hide all that under!

Some investors won't trust this amount of money to the eurozone banking system at the moment, because of fears that the dodgier banks and countries could infect the others and produce a contagion scenario.

So rather than trust the banks, they turned to the German state -- the only large eurozone member with a triple-A credit rating, which means that it is the least likely to default upon its financial obligations.

Worries about deflation

Another concern is deflation, the situation where prices fall over time in contrast to the inflationary increases that we've become used to. In deflationary times, loss-making investments like these bonds can still produce a positive real return. Japan experienced a period of deflation in the late 1990s and investors still made real returns even though they were receiving negative interest rates.

Let's say that you're paying 1% to the government to look after your money for a year during which time the Retail Price Index falls by 1.5%. You'll have made a real return of 0.5%.

Premium for security

From time to time, the Swiss government creates negative interest rates for some bank accounts by imposing taxes, in order to reverse the inflow of foreign money that is driving up its exchange rate and making their industry less competitive in the process.

When this happens, some investors are still prepared to take the loss because they want the security of having a bank account in a 'hard' currency whose real value won't be inflated away.

Similarly, at the height of the 2008 banking crisis, there was so much fear in the market concerning the banking system that investors were scrambling to buy US Treasury Bills, and this drove prices to the point where buyers were earning negative interest rates.

In turbulent times, many investors will choose to pay a big premium for safety.

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