Negative Interest Rates
This is such a confusing concept. Questions arise like what does it really mean and surely you don’t pay interest to the Banks?
Prior to the GFC interest rates were much higher than they are today. Then the world economy got into trouble so Central Banks around the world started lowering interest rates to revive economic growth. The theory is that if we are paying less interest on our loans we will spend more elsewhere and the economy will recover as more people will get jobs and everything will be ok, until next time anyway.
However the GFC was so frightening and the media did a great job of adding to that fear, much of the interest cost saving has been used to reduce loan balances and to save money. Also with an aging population in most of the developed world, lower interest rates meant less income, so less spending.
This didn’t stop Central Banks reducing rates further, down below 1% and they didn’t stop at zero and we have now had negative rates for many years in some countries.
What do negative rates mean?
Negative rates mostly apply to Government Bonds. This is where you invest money with a Government and they pay you interest say every 6 months and then at the end of the term you get all of your capital back. You are basically lending money to a Government. This generally works quite well, although those that invested in Greek Bonds a few years back would have had some nervous times.
Currently, approximately 30% of the world’s bonds are showing negative rates.
Recently there was a Bond issued by the Federal Republic of Germany, due to mature in 10 years. The interest rate it paid was zero. So you give the German Government money and they pay you zero interest. It gets worse, you had to pay 102.64 per Bond now and receive 100 in 10 years. Investors are guaranteed to lose money. (1)
The side effects are now increasingly spilling over from financial markets into the everyday financial transactions that people engage in. For example, Jyske Bank in Denmark this month started offering customers 10-year residential mortgages at a negative 0.5% interest rate and Swiss bank UBS announced that deposit accounts holding over 2m in Swiss Francs would incur a negative interest rate of 0.75%, forcing customers to pay them for the privilege of depositing money. (2)
Why would someone invest in a bond that is guaranteed to lose, even if a small amount?
Security, although this is not as certain as it may seem, is the best answer. The concept of investing with an established Government does provide a degree of peace of mind, especially if investors are concerned about the risks of investing in growth assets such as shares. Investors are paying to have their investment stored safely. Additionally some Pension (superannuation) funds around the world have rules that require them to invest part of their money in Bonds.
The value of a Bond can actually go up and down.
In financial markets, bonds are traded like shares, that is, investors buy and sell them. When you see the term ‘fixed interest’, it is the interest rate that is fixed not the capital value of the bond. The value of a bond depends on a number of things including the quality of the issuer (say the Australian Government vs a struggling company or country), the period of the bond until it matures and interest rates (actual and expected).
Investors constantly compare the returns on their current investments to what they could get elsewhere in the market. As market interest rates change, a bond's interest rate—which is fixed—becomes more or less attractive to investors, who are therefore willing to pay more or less for the bond itself. Here’s an example from Wells Fargo.
Suppose the ABC Company offers a new issue of bonds carrying a 7% interest rate. This means it would pay you $70 a year in interest. After evaluating your investment alternatives, you decide this is a good deal, so you purchase a bond at its par value: $1,000.
What if rates go up?
Now let's suppose that later that year, interest rates in general go up. If new bonds that cost $1,000 are paying 8%—or $80 a year in interest—buyers will be reluctant to pay the $1,000 face value for your 7% ABC Company bond. In order to sell, you'd have to offer your bond at a lower price—a discount—that would enable it to generate approximately 8% to the new owner. In this case, that would mean a price of about $875. (1)
What if rates fall?
Similarly, if rates dropped to below your original coupon rate of 7%, your bond would be worth more than $1,000. It would be priced at a premium since it would be carrying a higher interest rate than what was currently available on the market. (1)
Interest rates and bond prices have an inverse relationship
Even if rates are negative, the same principle applies. As rates fall to be further negative, the value of a Bond that is already losing money, becomes more valuable. In fact some of the best returns from the Bonds in the last year were Bonds that were already negative-yielding.
To quote a Fund Manager I was discussing this with, “it is mind-melting” and he manages bonds for a living.
Where is this heading?
The problem is that the financial markets have never been here before. Interest rates haven’t been this low or negative. When rates rise or there is an expectation of rate increases this will be very ugly.
As the rates on Bank Deposits and Bonds continue to fall, there is so much investment capital chasing other opportunities such as shares. This is pushing up shares prices. When interest rates begin to rise, some of this money will leave the sharemarket, creating falls and return to Bank deposits and Bonds.
It appears that rates will continue to fall for a period and it is hard to see them rising for some time, but they will do so at some point. Again no-one knows when the cycle of rate cuts will end and when the cycle of increases will begin.
What can you do?
The phrase “manage what you can control” again comes to mind. The markets will do what high-level investors and to a degree, Central Banks and Governments want them to do.
As an investor, you can only control where your money is allocated now and what to do when the situation changes. This is the stage of the cycle when having a lower than normal allocation to growth assets is appropriate and being prepared to further reduce the allocation when things get worse. It is not the time to be too worried about missing much of the higher returns that are around as markets peak.
Another point that I will be managing is what is defined as a defensive asset. Bonds will be ok for a period and may even be excellent if we have a recession, but when rates rise, they most likely will not be a good option. Around 1 year in 10 or so, cash is the best performer. It feels like that year is coming soon.
Finally, it is worth noting that many big investors have large cash reserves and are waiting for falls to take advantage of the lower prices to invest their money. This helps markets in the recovery phase. If possible this is a good strategy for part of your money. This too can be a risky strategy as holding money in cash at today's rates is also a risk due to the returns being below inflation.
Source Cuffelinks, Bloomberg.
Source Gopi Karunakaran, Ardea Investment Management, Livewire