Last week's unanticipated decision by the Bank of Israel to cut the interest rate to 2%, a two-year low, accentuated an odd phenomenon that's been bedeviling the nation's capital market for the past few months: negative yields on inflation-linked government bonds of up to two years.

What this means is that savings stashed away in what's generally considered the safest haven around are actually being eaten away. The overall implications for investors and the national economy, however, are open to debate.

Economists argue that the economy benefits from such a situation: Since government financing costs are lower, more can be put into social programs and pursuing expansionary policies. Investment managers, on the other hand, are left struggling to earn their clients positive returns in real terms.

Dr. Michael Sarel, Director of Economics and State Revenues at the Finance Ministry, explains that yields on government bonds are the product of three factors: market expectations for central bank rates in the upcoming period, interest rates in other countries and budgetary and geopolitical risks.

Last week's rate cut, along with expectations for more of the same, serve to strengthen the trend toward negative yields for linked bonds. "Increased market expectations that interest rates will drop means rising demand for inflation-linked bonds, so their prices go up - and the yields we get in real terms on these same bonds is negative," explains Sarel, who claims the world economy also fosters yields that are negative in real terms because of low interest rate levels in developed countries.

A look at world markets shows the trend running even deeper elsewhere, with negative yields stretching to government bonds with longer maturities in developed countries. For instance, 10-year inflation-linked U.S. bonds are trading at a yield of minus 0.8%, compared to a positive 1.62% yield on their Israeli equivalent. U.S. Federal Reserve Chairman Ben Bernanke has promised to keep rates low until mid-2015, as Sarel points out.

As for budgetary and geopolitical risks, Sarel explains that government bonds are now subject to surplus demand as a result of the Knesset election having been moved forward. "The risk attributed to the Israeli government's deficit targets being surpassed has decreased," he says. "In other words, the market expects the government formed after the election to pass a budget in line with the target."

Geopolitical risk has also declined with the calling of early elections, according to market pundits, by dispelling anxiety over the possibility of action being taken against Iran in the near future.

David Resnick, macroeconomic research manager at Leumi Capital Markets, says the reason for negative yields on government bonds is twofold: low interest rates and the fact that economists and investors don't expect the inflation rate to jump any time soon. The resulting decline in real (inflation-adjusted ) interest rates, according to Resnick, pushes real bond yields into negative territory.

Another explanation he gives for the negative yields is that investors throughout the world, and especially in Israel, are flocking to safe havens. "People are willing to pay more now for secure assets, even if it means their money will erode slightly," says Resnick. "They're afraid the alternative could result in heavier losses."

Keren Zadok, manager of bond funds at Migdal Capital Markets, claims this is a real problem for investors. "Anyone who invested in funds exposed to medium-range government bonds is losing money," she says.

Sarel, in contrast, tries to present the bright side. "If someone is deliberating whether to establish a business or invest in government bonds, in the present situation he'd be better off investing in the business," he says. "This could be expected to increase investment in equipment, plants, and machinery, to bolster economic growth and increase employment."

Reducing the risk and difficulties for Israeli companies in raising capital is another positive aspect noted by Sarel. "A company can generally raise money at a certain margin above the government bond rate," he explains. "A bank, for example, can raise money at a low yield today thanks to the low government interest rate."

But the best thing about low interest rates and negative bond yields, according to Sarel, is the decline in government interest expenses, leaving room to increase expenditures on social programs and in fields like education while also investing in growth. "The small investor may get hurt in the short run, but in the long run he'll be better off," he claims.

In Zadok's view, in light of disappointing global unemployment figures and other macro indicators, the overall picture can't be expected to change anytime soon. "Additional interest rate cuts in the near future are alluded to in the minutes of Bank of Israel meetings, and seeing interest rate hikes in the next few years is inconceivable," she says. "This all indicates expectations for the trend to continue for at least another year."

Resnick agrees with some of Zadok's arguments, but thinks the current interest rate level can't prevail for long. "Within a few years the world will come out of recession and interest rates of central banks around the world will rise, gradually bringing us back to the previous situation," he says. "I think the Bank of Israel will want to avoid any prolonging of negative real interest rates. If inflationary expectations rise the Bank of Israel won't continue lowering the rate but will start to gradually increase it, and we'll be back to seeing positive yields."

Two strategies

So how should one invest under these circumstances? Resnick explains that at the shorter end of the yield curve - bonds with durations of up to two years - interest rates are extremely low. He therefore recommends switching to bonds with longer durations.

"If we see a quick world recovery, the change will bring about a wave of interest rate hikes and investor losses," says Resnick. "We see medium-term bonds (with average durations of between two and five years ) as the most reasonable investment right now since the world probably won't see interest rate hikes in 2013. Toward 2014, however, we'll likely see some recovery."

Zadok suggests a different approach: Increase the portfolio's risk level by investing part of it in corporate debt. "Yields on unlinked and linked bonds in the corporate sphere can be expected to provide a 1.25% spread over the equivalent government bonds, meaning a return of 1% in real terms," she says.

As a simple way to avoid having to guess which bond will close the gap, Zadok advises buying a mutual fund that invests in bonds, both linked and unlinked, with short durations and high credit rankings. She says this will provide a high level of liquidity and broad diversification. "The issue of taxation is no less important, and is a whole lot simpler in the case of mutual funds than when buying bonds directly," she adds.