## Negative Interest Rates

April 28, 2015

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Imagine the following scenario: You wake up one morning and decide it’s time to open a new bank account. You gather your personal information, head to your local bank and sit down with a banker.

You: “I would like to open a new bank account.”

Banker: “Sure, what type of account are you interested in?”

You: “Well, I’m not sure, what are your interest rates?”

Banker: “Our current interest rate is negative 0.50%.”

You: “Come again?”

Banker: “Negative 0.50%.”

You: “So, if I deposit \$50,000, it will cost me \$250 per year?”

Banker: “Yes, but you could invest in our 2-yr CD. We have a new special rate of negative 0.25%”

While this scenario may seem far-fetched in the United States, it’s actually very common for European investors. European Government bond investors are finding negative interest rates commonplace, especially on the shorter end of the yield curve. Figure 1 shows bond yields (aka interest rates) for European Government debt at the end of February. Investors in Switzerland experience negative interest rates out 9 years! Germany and Netherland rates are negative up to 6 years. Finally, Sweden and France interest rates are negative up to 4 years. These investors are willing to pay governments to hold their money!

Figure 1 – European Government Curves Negative at Front End

Source: DoubleLine

A current look at 10-year government bond yields in the major developed countries tells much of the same story. The yield on a 10-year Switzerland bond is -0.10%, 0.16% in Germany, 0.29% in Japan and a whopping 1.92% in the United States. Before you rush out to buy a 10-year US government bond at 1.92%, consider the following: The average 10-year US government bond yield over the past 57 years is 6.24%! Clearly, this is a whole new world for bond market investors.

Currently you can invest in a AAA rated bond issued by Microsoft and earn 2.5%. Or, you can buy a AAA rated Swiss government bond and earn -0.10%. Why in the world would you choose the Swiss bond? Where are the buyers of this and other short-term government debt? The simple answer is Central Banks (governments), especially in Europe and Japan where rates are basically zero. They buy these bonds to suppress interest rates and remove the asset from the market pushing investors into riskier assets such as stocks, corporate bonds (like Microsoft), real estate etc. The hope is these activities will help boost inflation and economic growth. The US Central Bank has slowed their bond buying programs, but still hold 4.45 trillion dollars on their balance sheet. Simply holding this amount of debt still provides stimulus and keeps interest rates low.

How does this affect me?

While you may not be an investor in the European Government bond market, negative to slightly positive government bond yields have a tremendous effect on many markets, such as:

• Interest rates earned on deposit accounts, money market and short-term CDs have been basically zero for 6 years. An estimated 3+ trillion of interest income in the US has been lost since 2009.
• Low interest rates have boosted many stock markets, especially here in the United States.
• Demand for “higher yielding” instruments such as high-yield bonds, REITs, MLPs, and dividend paying stocks has been strong and in many cases stretched valuations.
• More recently, higher US yields has translated to a strong US dollar relative to other global currencies.
• Companies can borrow money at historically low interest rates.
• Institutional investors and hedge funds have increasingly used cheap leverage to boost returns.
• The housing market has been aided by continually low mortgage rates.

Clearly, anyone with a bank account, bond mutual fund or a mortgage is affected by the level of government bond yields.

Portfolio Implications

Unless you keep all your money under your mattress, developing strategies for fixed income instruments is more important than ever. Short-term Interest rates in the United States look poised to go higher as the Federal Reserve will most likely increase short-term rates this year. However, the speed of Fed hikes is much more important than the first hike. European and Japanese government bond yields looks like they may stay low for a long time, possibly the rest of the decade. At some point interest rates around the world must go higher. Investors must find high quality bonds at current historically low interest rates, yet keep one eye focused on the future path of interest rates.

• Active management, either buying individual bonds outright or through mutual funds, is an important strategy in today’s market.
• Carefully selected individual municipal bonds held to maturity continues to be a good strategy. Laddered, as well as barbell strategies, can both work in today’s market.
• Managers than can successfully navigate short to intermediate-term high quality and high yield strategies are in short supply, but are available.
• So called “unconstrained” strategies have become popular. However, many of these strategies are new, complicated, and pricey. Venturing into this market requires mangers with a long track record of managing money in the bond market, an understandable investment strategy, and lower than average costs. Again, these managers are in short supply, but are available.
• International and emerging market bond strategies look attractively valued as long as investors understand and are comfortable with the added risk.

Markets By The Numbers

Stocks

International developed stocks outpaced US stocks in the first quarter aided by aggressive actions taken by the European and Japanese Central Banks. Emerging market stocks caught a bid, returning 2.24% for the quarter. Valuations remained a concern for US stocks, however a strong end to the quarter enabled all indices to be positive at quarter end. 2000 and 2009 taught investors that momentum can propel overvalued markets even higher. Stock investors have been rewarded over the past 5-years, especially in the US as many markets have produced 10%+ annualized returns.

Bonds

High-yield and emerging markets saw strong returns in the quarter. Core bonds as represented by the Barclays Aggregate Bond market continued its upward march despite much caution by market participants. A strong dollar hurt the developed international bond market. Cash, under the mattress or in short-term instruments, remains at zero.

Commodities/Currencies

The story of the quarter was the US Dollar as it rallied 8.1%. Divergent monetary policies and higher government bond yields in the US were the main factors contributing to a strong dollar. Commodities continued to be weak and are now negative over the past 10 years. Low economic growth, low inflation and a strong US dollar all contribute to low commodity prices. At some point, these factors will reverse, and those with exposure to commodities may benefit from today’s low prices.

Balanced Portfolio

A balanced portfolio of 60% world stocks and 40% bonds rose 2% in the first quarter. This same portfolio has gained 8.1% annually over the past 5 years and 6.1% annually over the past 10 years.