What causes negative interest rates? How might investors respond?
Updated: May 13, 2020
I was asked by a friend why there are more than $17 trillion of negative yielding global bonds. A negative yield means investors pay the government or a corporation to 'safely' hold their money. Investors in Germany, for example, are willing to pay a premium -- and ultimately take a loss -- to get the safety of high quality government or corporate bonds. If you purchase 100,000 euros of German government bonds, you 'pay' $674 euros a year for the government to hold your money for 10 years. By some measures, 17% of the total global bond market is paying negative interest rates to investors ($17 trillion of approximately $100 trillion). This problem for investors could get worse before it improves. The economies of Japan, the Euro Zone, and China have all experienced significant slowdowns. The data in the U.S. are mixed, especially given record levels of student debt and the trade war with China. When economies slow down, central banks and policy makers call for further interest rate reductions instead of spending government money (aka fiscal stimulus) or cut taxes.
How did we get here?
In response to the 2009 financial crisis the European Central Bank, the Bank of Japan, and the U.S. Federal Reserve slashed short term interest rates to basically zero and purchased trillions of dollars of longer maturity bonds to drive interest rates across maturities (1 year, 5 year, 10 year, etc.) to historic lows. Following the financial crisis, major corporations became quite profitable (in part because of ultra-low borrowing costs) and have built up record amounts of cash on their balance sheets. Corporations do not want to invest in risky stocks, instead they hoard cash to buy back their own stock, pay dividends to shareholders, invest in research and development, or make major investments in factories or equipment. Sitting on record levels of cash, a corporate treasurer whose CEO and board members want it safely invested, has very limited options. So, the treasurer buys the safest government bonds and the highest rated corporate bonds she can find. Or, she purchases money market funds that essentially buy the same debt with shorter maturities. In addition, pension funds are willing to pay more for long-dated bonds and accept lower yields to match future retiree payouts (liabilities). Finally, add in aging populations across the globe (baby boomers in the U.S. for example) who are reducing risk by selling equities and purchasing government and corporate bonds. The 'pile-on' effect of central banks, corporate treasurers, pension funds, retirees all needing a safe place to store ridiculous amounts of cash has overwhelmed demand causing prices for bonds to bid up so high as to make the return (annual % income or 'yield') to investors negative.
Where are U.S. rates today?
In 2011 2 year rates in the U.S. dropped to near zero, around 0.15% and stayed extremely low until the Federal Reserve began raising rates at the end of 2015. Recent 2 year rates in the U.S. were 1.47% and 10 year rates also touched that level (week of 9/3/2019). While negative 10 year treasury rates seem a long way off --- bond prices would have to rise almost 20% -- I doubt that investors in Germany thought they would be paying the government to hold their cash. And, the Federal Reserve in the U.S. is poised to lower short term rates for the 2nd time during 2019 this week.
As an investor what can I do?
Consider your future cash flow needs and decide whether you can accept today's interest rates (at different maturities) to meet your needs. You may want to consider how to ladder a portfolio of bonds or ETFs to meet your spending needs. Or, if you are saving for decades into the future, you could review your stock/bond mix and the average maturity of your bond investments. Finally, you might talk with your financial adviser about whether it is a good idea to stay in lower risk governments bonds or invest in higher risk corporate bonds. You may consider substituting some alternative investments (for example, hedge funds with returns less correlated to the equity and bond market) or equities for a portion of your bond portfolio. Your response depends on your investment risk tolerance and individual goals.
You can check your risk tolerance using Riskalyze here: https://www.peakwealthplanning.com/client-tools
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