10/03/2016

Official interest rates in Japan and Europe are now negative. Since these rates act as a benchmark for bonds, yields on many fixed income securities are also now below zero. What are investors to make of this?

The idea of negative interest rates can be tough to grasp. Essentially, it means that you pay a bank to look after your funds, instead of the usual practice where the bank pays you regular interest for having temporary custody of your money.

Central banks, whose job it is to implement a government’s monetary policy and issue currency, attempt to influence market interest rates by setting the rate commercial banks earn for depositing cash with them overnight.

The European Central Bank, along with peers in Japan, Switzerland, Sweden and Denmark, have all at times adopted negative interest rates recently in the face of very low inflation and the prospect of outright deflation, or falling prices.1

During a period of falling prices, real interest rates can be rising even if nominal interest rates are being cut. In such an environment, businesses and consumers may put off investing and spending on the view that it will be cheaper tomorrow.

This broadly is why central banks in those countries are cutting rates to zero or below zero. They are trying to lift inflation expectations, disincentivise saving, and, in turn, boost economic activity.

Figure 1 below shows overnight interest rates in some developed economies as of early March, 2016. These are the deposit rates that central banks set for commercial banks to leave funds with them overnight. The commercial banks in turn base their own lending rates to customers on the central bank benchmarks.

That’s all very well, you might say. But why would anyone want to pay a bank to look after their money? Why not just put the money under the mattress?

Well, first, it’s not very practical, or indeed safe, to store large amounts of cash at home. Second, some people are so focused on return of their capital over return on their capital that they are willing to pay banks to look after their money.

NEGATIVE BOND YIELDS

As well as overnight rates set by central banks and affecting retail deposits, yields on government bonds in a few countries have recently been below zero, in some cases out to maturities of 10 years or more, as in Switzerland and Japan.

Negative yields reflect both supply and demand factors, as well as the low inflation environment. On the supply side, central banks in Europe and Japan are still carrying out a policy called ‘quantitative easing’. This means that along with keeping overnight lending rates below zero, they are buying government bonds in a bid to flood the system with money and generate a self-sustaining economic recovery.

On the demand side, these negative bond yields might reflect a high degree of risk aversion among some investors. The emphasis in these cases is again more on capital preservation than on growth.

In terms of the economic environment, expectations that inflation will remain very low ameliorates one of the key risks for bond investors in that rising prices erode the purchasing power of the bond’s future cash flows.

DO BONDS STILL MAKE SENSE?

For global fixed income investors, negative interest rates and bond yields below zero may spark concern. But does it still make sense to invest in bonds at this time and what does it mean for returns from diversified portfolios?

There are a number of responses to those questions. First, interest rates and yield curves (the trajectory drawn by bonds of the same credit quality but different maturities) are not the same in every country. For example, policy rates in the USA, the UK, Canada, Australia, New Zealand and Norway are still positive.

Rates vary because economic conditions, demand and supply factors vary across countries. The US, for instance, began raising rates from near zero late last year amid evidence of strengthening activity. Australian cash rates are around 2%, among the highest in the world.

So these different interest rate structures in different markets provide us with a diversification opportunity. Figure 2 is a snapshot of the shape, as at 31 December 2015, of five different yield curves–Australia, the US, the UK, the Euro and Japan.

Second these overseas bond returns may not be negative once they are hedged back to local currencies using local interest rates. With Australian cash rates at 2% and New Zealand’s at 2.5%, that becomes the floor for investment in global bond markets.

Hedging provides the diversification benefits of different yield curves without the currency risks. Figure 3 shows how this works.

Third, what matters to investors is not so much the absolute level of yields, but how theychange. Yields and price are inversely related, so when yields fall, prices rise. That means that even if yields are negative, they could still fall further and provide a positive capital return.

Fourth, the shape of a yield curve is more important than the absolute level of yields. For an example, an individual curve can still be upwardly sloping even if it is below zero. (In this case, shorter-term yields are below longer-term). That gives you the option of taking more term risk and getting the benefit when yields fall (prices rise).

Finally, regardless of the interest rate cycle, bonds still play a diversification role in a portfolio composed of multiple asset classes in equities, property, cash and bonds. This is because they behave differently to those other assets.

SUMMARY

In summary, while interest rates and bond yields have turned negative in some economies as central banks attempt to stimulate activity, this doesn’t obviate the important role fixed interest can play in a diversified portfolio.

The benefits of taking a global approach to fixed interest, varying term exposure according to the range of opportunities available and hedging out currency risk remain as strong as ever.

As to the broader implications of negative interest rates for investment markets, we have not seen this phenomenon for a sufficient time to draw any firm conclusions.

In the meantime, don’t go rushing to put your money under the mattress.