LIFE IN A SUB-ZERO CLIMATE: GETTING USED TO NEGATIVE INTEREST RATES

17th May 2016

Why would any investor agree to pay negative interest rates? Surely the whole reason for investing is to maximize your returns. Despite this, as at the end of April 2016 there were USD$9.9 Trillion of bonds and bills on issue which carry negative interest rates. This figure amounts to 16% of all global government bond indices. The average interest rate of (minus) -0.24% means that investors are paying a total of USD$24 billion per year for the privilege of owning these bonds.

Since the European Central Bank introduced negative interest rates in June 2014, the phenomenon has spread to Denmark (September 2014), Switzerland (December 2014), Sweden (February 2015) and Japan (January 2016). In each case the central bank imposed negative rates on accounts held there and the term structure of interest rate meant that the yields on short-dated government bonds soon dropped into negative territory.

Investors seeking higher yields switched to similar bonds in the neighboring countries of Austria, Germany and the Netherlands. As we know, bond yields fall when bond prices rise, so the yields on these bonds also turned negative. Furthermore, some of the central banks have lowered their cash rates since then, adding to the downward pressure on bond yields.

There is one important limit to the spread of negative interest rates. Retail depositors do not have to accept them, because they can just keep their cash at home in a safe. These options are not open to wholesale depositors, who are often legally obliged to own certain quantities of assets. In any case, there are practical obstacles to hiding a hundred million dollars under your mattress. Due to the fact that retail deposit rates can’t go below zero, banks’ net interest margins (NIM) on retail deposits get compressed when rates go negative.

The mechanisms for paying negative interest are simple. In the case of accounts held at banks and central banks, the interest is deducted regularly, like account charges or a fund’s management fees. In the case of money market instruments like bank bills, the investor pays $100 for the instrument but is repaid only $99 at maturity.

Why do investors pay negative interest rates?

  • An investor who deposits Euros in a Swiss franc account can produce large returns from foreign exchange movements, so a small loss on the interest paid is not important.
  • If bond yields become more negative over the life of a two-year bond, e.g. from (minus) -0.25% to (minus) -0.50%, then the bondholder will make a capital gain on the value of the bond.
  • If you are extremely risk averse, you may think that it is better to lose 0.5% p.a. on a bank deposit than to risk losing 10% in the share market.
  • Some types of investor are forced to invest in this asset class. If a Japanese bond fund has rules which require it to be fully invested in yen denominated bonds, it must invest in that asset class no matter how negative the return is. Similarly, a European pension fund may be obliged to invest at least 20% of its assets in Danish or Swedish bonds.

Investors who need certain levels of return will of course try to find other ways of achieving their return targets. If they stay in government bonds, they can get higher yields by buying bonds with longer maturities, e.g. ten years rather than two years. Switching from government bonds to corporate bonds will also produce higher yields, more so if you accept bonds of lower quality. Investors can also put more of their portfolio in equities or alternative assets which offer higher yields… but all of these solutions mean that the investor is taking on more risk.

Why do central banks impose negative interest rates on their depositors and why do they want bond yields to be negative? The main reason given is  “ to stimulate the economy”. Negative interest rates penalize banks for leaving money idle by not lending it out. Lower bond yields reduce the cost of capital to companies, encouraging them to invest. To the extent that negative interest rates reduce banks’ lending rates, they also encourage consumers to borrow.

There is another important reason, but it is not so widely proclaimed. Global trade agreements contain clauses which are designed to prevent a repetition of the competitive currency devaluations of the 1930s. A devaluation by one country might provoke retaliatory action by its trading partners. The introduction of negative interest rates, however, tends to push the local currency downward in a less obvious way, because investors seeking yield will shift their money to countries where bond yields are higher. The Danish, Swedish, Swiss and Japanese economies all have their own currencies  and negative interest rates have tended to exert downward pressure on each currency.

Negative interest rates do have negative effects on some sectors in the financial services industry. As noted above, they tend to reduce banks’ profitability because they reduce banks’ net interest margin  (which is the spread between deposit rates and lending rates). However, negative interest rates have already led to the strange situation where some mortgage borrowers get paid interest instead of paying interest.

On some European loans, the interest rate payable is set on the basis of a benchmark (such as the three-month European InterBank Offered Rate, or Euribor) plus a premium. If the benchmark goes below zero by more than the amount of the premium, then the interest due will be negative. This has begun to happen with some Euro denominated floating rate notes issued by the Australian banks, as well as with some mortgage borrowers in Denmark, Portugal and Spain.

Negative interest rates will also prove painful in the short term and the long term for pension funds, general insurers and life insurers. The short term effect is to reduce current income to very low levels which are insufficient to pay pensions (especially in defined benefit funds) or to meet life insurance payout expectations. In the longer term, general insurers won’t be able to earn any investment income on the float, and life insurers will face shortfalls on their capital guaranteed products.

Will negative interest rates come to Australia? We don’t think so. With official cash rates at 1.75%, another seven cuts of 25bp cuts would be needed to get down to 0.0% or ZIRP (“Zero Interest Rate Policy”). Government bond yields usually reflect a country’s prospects for economic growth and inflation. Low GDP growth and low inflation imply low bond yields, and the countries where negative interest rates exist now are all economies which have low GDP growth and low inflation. In Australia and the US, by contrast, growth and inflation are higher, partly because long term population growth underwrites economic growth, so Australian and US bond yields are high relative to other developed countries. There is also the example of China, which has no population growth but very high economic growth and high inflation: not surprisingly, it also had high bond yields.

10-year Government Bond Yields

Switzerland         -0.30%
Japan               -0.11%
Germany             +0.12%
Sweden              +0.49%
UK                  +1.38%
USA                 +1.70%
Australia           +2.27%
China               +2.91%

Neill Colledge

Q.E.D.