Negative Interest Rates

Paul Hancock, CFP®    April 28, 2015

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 farfetched 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.

Who buys this stuff?

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.

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. 

DISCLOSURES

INDEX DESCRIPTIONS

All indexes are unmanaged and an individual cannot invest directly in an index. Index returns do not reflect fees or expenses.

The MSCI ACWI (All Country World Index) Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. As of June 2009 the MSCI ACWI consisted of 45 country indices comprising 23 developed and 22 emerging market country indices.

The S&P 500 Index is widely regarded as the best single gauge of the U.S. equities market. This world-renowned index includes a representative sample of 500 leading companies in leading industries of the U.S. economy. Although the S&P 500 Index focuses on the large-cap segment of the market, with approximately 75% coverage of U.S. equities, it is also an ideal proxy for the total market. An investor cannot invest directly in an index.

The Russell 3000 Index® measures the performance of the 3,000 largest U.S. companies based on total market capitalization.

The Russell Midcap Index ® measures the performance of the 800 smallest companies in the Russell 1000 Index.

The Russell 2000 Index ® measures the performance of the 2,000 smallest companies in the Russell 3000 Index.

The MSCI® EAFE (Europe, Australia, Far East) Net Index is recognized as the pre-eminent benchmark in the United States to measure international equity performance. It comprises 21 MSCI country indexes, representing the developed markets outside of North America.

The MSCI Emerging Markets Index SM is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of June 2007, the MSCI Emerging Markets Index consisted of the following 25 emerging market country indices: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.

The Dow Jones Composite REIT Index measures the performance of Real Estate Investment Trusts (REIT) and other companies that invest directly or indirectly through development, management or ownership, including properties.

The Dow Jones-UBS Commodity Index is composed of futures contracts on physical commodities and represents twenty two separate commodities traded on U.S. exchanges, with the exception of aluminum, nickel, and zinc.

The Barclays Capital U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indexes that are calculated and reported on a regular basis.

The Barclays U.S. Treasury Index is U.S. Treasury component of the U.S. Government index. Public obligations of the U.S. Treasury with a remaining maturity of one year or more.

Treasury bills are excluded (because of the maturity constraint). Certain special issues, such as flower bonds, targeted investor notes (TINs), and state and local government series (SLGs) bonds are excluded. Coupon issues that have been stripped are reflected in the index based on the underlying coupon issue rather than in stripped form. Thus STRIPS are excluded from the index because their inclusion would result in double counting. However, for investors with significant holdings of STRIPS, customized benchmarks are available that include STRIPS and a corresponding decreased weighting of coupon issues. Treasuries not included in the Aggregate Index, such as bills, coupons, and bellwethers, can be found in the index group Other Government on the Index Map. As of December 31, 1997, Treasury Inflation-Protection Securities (Tips) have been removed from the Aggregate Index. The Tips index is now a component of the Global Real index group.

The Barclays Short Treasury Index includes aged U.S. Treasury bills, notes and bonds with a remaining maturity from 1 up to (but not including) 12 months. It excludes zero coupon strips.

The Barclays Municipal Bond Index is a rules-based, market-value-weighted index engineered for the long-term tax-exempt bond market. To be included in the index, bonds must be rated investment-grade (Baa3/BBB- or higher) by at least two of the following ratings agencies: Moody's, S&P, Fitch. If only two of the three agencies rate the security, the lower rating is used to determine index eligibility. If only one of the three agencies rates a security, the rating must be investment-grade. They must have an outstanding par value of at least $7 million and be issued as part of a transaction of at least $75 million. The bonds must be fixed rate, have a dated-date after December 31, 1990, and must be at least one year from their maturity date. Remarketed issues, taxable municipal bonds, bonds with floating rates, and derivatives, are excluded from the benchmark.

The Barclays U.S. Corporate Investment Grade Index is the Corporate component of the U.S. Credit index. Publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. To qualify, bonds must be SEC-registered.

The Barclays U.S. Corporate High Yield Index covers the universe of fixed rate, non-investment grade debt. Eurobonds and debt issues from countries designated as emerging markets (sovereign rating of Baa1/BBB+/BBB+ and below using the middle of Moody’s, S&P, and Fitch) are excluded, but Canadian and global bonds (SEC registered) of issuers in non-EMG countries are included. Original issue zeroes, step-up coupon structures, 144-As and pay-in-kind bonds (PIKs, as of October 1, 2009) are also included.

The Barclays Global Aggregate Bond Index provides a broad-based measure of the global investment-grade fixed income markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The index also includes Eurodollar and Euro-Yen corporate bonds, Canadian government, agency and corporate securities, and USD investment grade 144A securities.

The Barclays Emerging Markets USD Aggregate Index is a flagship hard currency Emerging Markets debt benchmark that includes USD denominated debt from sovereign, quasi-sovereign, and corporate EM issuers. The index is broad-based in its coverage by sector and by country, and reflects the evolution of EM benchmarking from traditional sovereign bond indices to Aggregate-style benchmarks that are more representative of the EM investment choice set. Country eligibility and classification as an Emerging Market is rules-based and reviewed on an annual basis using World Bank income group and International Monetary Fund (IMF) country classifications. This index was previously called the Barclays US EM Index and history is available back to 1993.

DISCLOSURES

Past performance is no guarantee of future results. Diversification does not assure profit or protect against a loss in a declining market. While we have gathered this information from sources believe to be reliable, we cannot guarantee the accuracy of the information provided. The views, opinions, and forecasts expressed in this commentary are as of the date indicated, are subject to change at any time, are not a guarantee of future results, do not represent or offer of any particular security, strategy, or investment and and should not be considered investment advice. Investors should consider the investment objectives, risks, and expenses of a mutual fund or exchanged traded fund carefully before investing. Furthermore, the investor should make an independent assessment of the legal, regulatory, tax, credit, and accounting and determine, together with their own professional advisers if any of the investments mentioned herein are suitable to their personal goals.

International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Small and mid-cap stocks carry greater risks than investments in larger, more established companies. Fixed-income securities are subject to interest-rate risk. Investing in high-income securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. Investing in commodities is generally considered speculative because of the significant potential for investment loss due to cyclical economic conditions, sudden political events, and adverse international monetary policies. There are several risks associated with alternative or non-traditional investments above and beyond the typical risks associated with traditional investments including higher fees, more complex/less transparent investment strategies, less liquid investments and potentially less tax-friendly. Some strategies may disappoint in strong up markets and may not diversify risk in extreme down markets.

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