As if pulled by gravity, interest rates across the globe have been falling since the financial crisis. In the U.S., the yield on a 10-year Treasury has fallen from 5 percent in mid-2007—which was not far from its nearly 60-year average of approximately 6 percent—all the way down to 1.47 percent in August. As shown in Figure One, virtually all of the instances when the 10-year Treasury’s yield fell below 4 percent have occurred since 2007.
Within the U.S., the impact of falling rates has been mixed. Low interest rates have helped stimulate the economy by reducing borrowing costs for both consumers and businesses. Everything from borrowing to buy a house or car to issuing bonds to build a factory or buy back stocks has been cheaper as a result of lower interest rates. And because bond prices move opposite yields, investors have seen strong total returns from bond portfolios through the combination of price appreciation and yield.
On the other hand, savers looking for interest income from their savings or retirees trying to generate reliable streams of income from their retirement assets have suffered.
In many parts of the world, the situation is even more extreme. Unlike Newton’s apple, which stopped falling once reaching the ground, interest rates in some countries have continued falling below 0 percent—into negative territory. The phenomenon of negative interest rates, once viewed as a financial oddity, now represents a sizable and growing share of the global bond market. Worldwide, more than $17 trillion of bonds carry negative yields. That number represents about 30 percent of the global bond market, according to a recent Bloomberg article on the topic.
But what are negative interest rates and how did we get to this point? Why would anyone tolerate them? And what should an investor do in a world turned on its head?
The World Turned Upside Down
One way to think about interest rates is that they represent the price of money. If you want to borrow more of it, it is only reasonable to expect to pay lenders for the privilege. We all know that there is no free lunch.
For corporations and governments, such borrowing typically takes the form of issuing bonds. Like a mortgage, the issuer of the bond (the borrower) agrees to repay the face value of the bond (the loan amount) at the maturity of the bond to the investor (the lender), along with a stated amount of interest. This is the way the bond world has worked for thousands of years. In fact, as shown in Figure Two, scholars can trace the interest rates on bond issuances as far back as 3000 B.C.
As a larger share of the global bond market flips into negative interest rate territory, we have seen some shocking headlines. A recent USA Today headline read, “Bank will pay customers to take out mortgages by offering negative interest rates in Denmark.” In a world where the interest rate is negative, not only is the lunch free, but the restaurant is paying you to dine there.
Here is a scenario to help illustrate how such a bizarre event could occur. If the coupon on a 10-year U.S. Treasury was 1.625 percent and you were to purchase $100,000 of this bond at par value—or $1,000 per bond—you would receive $1,625 in interest payments each year. And at the end of 10 years, you would receive back your $100,000 in principal. Because the entirety of your initial investment was returned to you, the total return on this bond is represented by the annual coupon payments, and you would have enjoyed a yield of 1.625 percent.
Now imagine you are a bond investor in Germany, where interest rates have turned negative. Instead of paying par for a 1.625 percent coupon bond, you may have to pay a premium over par. For example, you could pay $127,000 for a bond with a face amount of $100,000. Because coupon payments are calculated against the face value of the bond—not the price paid—you would receive the same $1,625 in interest income each year as the U.S. investor, and you would likewise receive a $100,000 return of principal in ten years.
In this case, the total return of the bond is not equal to the 1.625 percent interest received. Because the cumulative amount of interest payments—or $16,250—is not enough to offset the $27,000 premium paid upfront, the annualized total return on the bond becomes a bizarre -1 percent.
Even if the bond math illustrated above makes sense, an important question remains: Why would a rational investor choose to buy this value-eating, negative-yielding bond? There could be several reasons:
- Negative inflation. Even if an investor loses a little bit of purchasing power due to negative interest rates, if the overall level of prices in the economy decreases more, he or she still comes out ahead.
- Profit motive. Instead of holding the bond to maturity, an investor may believe that already-negative rates will decline further. If that happens, he or she can sell the bond and make a profit. This is referred to as the greater fool theory.
- Risk aversion. If an investor is concerned about the future prospects of the stock market and other risky assets, a slightly negative interest rate may be acceptable as “the devil you know.”
- No choice. Some investors with structural needs, such as insurance companies or pension plans, are required to match a future guarantee with current assets. They may simply have no choice but to invest in negative-yielding bonds.
- Passive investors. A passively managed mutual fund or exchange-traded fund that seeks to mirror a bond market index would purchase bonds regardless of yield so that it can meet its investment objective.
- Noneconomic buyers. Some buyers, such as central banks trying to inject liquidity into their economic systems to stimulate growth, are simply not price-sensitive buyers. They have other goals and would purchase bonds regardless of negative yields.
How Did We Get Here?
Central banks, such as the U.S. Federal Reserve and the European Central Bank (ECB), cut policy interest rates—such as the fed funds rate—to stimulate their countries’ economies. Lower interest rates make it less expensive for borrowers to borrow and provide less incentive for savers to hoard cash. As shown in Figure Three, the Federal Reserve began to cut short-term interest rates in 2007, taking the fed funds rate from 5.25 percent all the way down to 0.25 percent by the end of 2008. The ECB followed suit, cutting its short-term rate from 3.25 percent in 2008 to 0.25 percent by mid-2009.
Although their policy actions were similar, the results of these actions in the U.S. and Europe have been quite different. Monetary stimulus, combined with the more dynamic economic underpinnings in the U.S., helped stabilize the economy and restart growth. By 2015, with an unemployment rate of 5 percent—down from 10 percent in 2009—and inflation beginning to reemerge, the Federal Reserve had begun to reverse course and raise rates.
Facing the challenges of a less dynamic economy, demographic headwinds, and continued bank weakness, the response to rate reductions in Europe was less robust. European banks, still struggling to rebuild their capital reserves, were content to hold excess reserves at the ECB—even if they earned no interest—rather than lend out much-needed capital to businesses and consumers.
This prompted the ECB to embark on an economic experiment on a grand scale; it reduced short-term policy rates below 0 percent in mid-2014 with follow-on rate decreases moving the policy rate to -0.4 percent, where it stands today. This dramatic policy was intended to provide a jolt to the system. If deposits were penalized through the direct cost of negative rates, banks should be much more willing to lend.
So far, this policy has failed to work. And this extreme policy has also raised concerns about the potential unintended consequences, such as asset bubbles, if investors hungry for yield seek out ever-riskier investments.
How Long Can Low Rates Persist?
Despite the stronger economic picture in the U.S., recent concerns over the negative impact of trade tensions have placed downward pressure on interest rates. The Federal Reserve again responded to slowing growth prospects with its primary monetary policy tool. At the end of July and again in late September, it reduced the fed funds rate by one-quarter of 1 percent.
Importantly, the U.S. has also shown a willingness to employ another powerful policy tool: fiscal stimulus. The passage of the Tax Cuts and Jobs Act provided fuel to the growth engine in the form of corporate and individual tax cuts and increased government spending. Notwithstanding longer-term concerns over the size of government budget deficits and the national debt, the combination of monetary and fiscal policy has proven to be potent. Like oars in a canoe, these policy tools are best when used together.
So far, Europe has not shown a willingness to use its fiscal tool. In fact, Germany has moved in the other direction, reducing government debt over the last nine years. Like a canoe with one oar, Germany has been traveling in circles rather than toward its intended destination.
If the headwind of global trade tensions were reduced meaningfully, the U.S. economy could regain its growth footing and this, combined with higher debt levels, could pressure rates higher. Europe, on the other hand, could face exceptionally low—or negative—rates for longer given its structural issues.
Investor Impact of Low (and Negative) Rates
The concept of negative interest rates is enough to leave readers and investors scratching their heads—especially those in or nearing retirement with a need to generate income. It is a challenge likely to persist for some time, even if negative rates do not materialize on U.S. shores. It appears that our current low-interest-rate environment is not going away any time soon.
Investors should heed a few important reminders as we consider the effects of an extended period of low or negative global interest rates:
- Lower interest rates, while signaling lower income ahead, have served to boost the price of bonds and other investment assets, such as real estate and stocks. As shown in Figure Four, in 2019, every $1 of increased bond prices has been accompanied by a $2 increase in stock prices. Through the end of September, the total returns for U.S. bonds and stocks are approaching 10 percent and 21 percent, respectively.
- Fixed income is still an important part of a diversified investment portfolio. Bonds remain an important tool to counterbalance stock market volatility. And although investors should expect less from their bonds in the next several years, they will still provide income to portfolios.
- Investors should consider alternatives to stocks and bonds. Where appropriate, diversifying investment categories such as infrastructure, real estate, private equity, and credit may offer risk reduction and market returns that are less correlated to traditional asset classes.
As always, an investor’s best defense against uncertainty is a diversified portfolio that is properly matched to his or her tolerance for and ability to withstand risk. In a world with low, if not negative interest rates, having a sound financial plan that considers long-term income needs relative to sources of income and the need to preserve principal becomes even more important.