The Shock of Negative Interest Rates

November 15, 2019 | Michael Tse


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How did we get negative yields and what does it mean for investors?

The concept of a negative interest rate is strange to many. The general belief is that if a person is willing to lend to those who want to borrow, they should be compensated with a return. Currently, this longstanding concept has been flipped upside-down with the surge of negative interest rate bonds in the market.

Faced with a slowing global growth and aging demographics that resulted in more savings and less capital investments, Central banks all around the world have been lowering interest rates to encourage borrowing and investments in an attempt to boost economic growth. With the European Central Bank (ECB) pushing rates further into negative territory, other central banks have followed suit. Shocking to many, Danish banks are offering negative rates on first mortgages. Imagine - getting paid to take a mortgage! This negative interest rate environment is widespread. The table below shows the current landscape of global yields and illustrates that close to $16 trillion of debt is negative-yielding.

So far, negative yields have not really cost investors. For example, the ECB overnight deposit rate is -0.5%. This is the rate that the ECB charges to banks that have excess reserves. The banks generally have been eating the cost of negative yields instead of passing it onto their retail customers. As the global central banks push further into negative territory, the cost of negative yields may start impacting retail investors. Certain deposit notes in the Eurozone have already been issued with premium prices (over par) and zero percent coupons. This means they will mature at par resulting in a negative yield.

Will negative yields start appearing in North America and how should we navigate this environment?

The biggest question is whether the U.S. debt market, currently measured at $25 trillion of treasuries and investment-grade corporate bonds, will have a similar fate. At first glance, many believe that the negative-yielding environment will drag down US rates. As the US yields still carry a positive yield, increased demand from international investors has led to the US yield to fall. Historically speaking, the U.S. 10-year Treasury on average yields 0.20% more than the German 10-year Bund. At the end of October, the gap has widened to 2.2% (10-year Treasury of 1.6% vs. 10-year Bund of -0.6%) since the EU has aggressively lowered rates and the US had previously been raising rates. Investors should expect the 2.2% gap to narrow as the US Fed has already begun cutting rates in response to waning economic growth. In the event of a recession, we cannot rule out that the US Fed would trend towards zero percent if not flirt with negative yields.

How to invest in Bonds in this envrionment

With the rate environment so low with minimal returns, many investors wonder if fixed income and bonds still make sense in a portfolio. It is important to remember that a key benefit of a bond is its ability to preserve capital and to provide ballast to a portfolio in times of volatility. Hence, bonds still do belong in balanced portfolios. Some active bond investors believe that there could still be outsized gains in bonds. Should interest rates fall lower, there would be price gains for bonds. However, for those investors who want to avoid trading bonds and speculating as to what direction interest rates will go, we would recommend a simpler approach called the “Pull to Par” strategy. Investors can work with their advisor to purchase high quality, short to medium-term bonds that are priced below par (example: $97). These bonds are meant to be held and not traded. They will mature to $100 with minimal price volatility resulting in a respectable return above a GIC. These returns are considered capital gains, so for those investing in non-registered accounts, the net after-tax return is further enhanced. With this approach, investors can save themselves from the increased uncertainty in the bond market. We encourage investors to speak with their advisor to assess whether this approach is suitable for their portfolio.

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