Interest Rates – How Low Can They Go?
According to Bloomberg data, the world’s stockpile of negative-yielding debt nearly tripled in size from just a year ago. This phenomenon was born of unorthodox monetary policy carried out by central banks – namely, those in Europe first and then Japan – in the hope of boosting economic activity in their sluggish economies, as lower interest rates stimulate growth by encouraging borrowing. When low rates did not appear to fully accomplish their goals, central banks pushed their key benchmark lending rates into negative territory. From there, the policy spilled over into a range of fixed income securities, including government debt and even corporate bonds. For investors in such negative-yielding debt, holding to maturity guarantees a loss. Who would be game for this? Apparently, a horde of folks as there has been surprisingly healthy appetite for the debt in the global markets. In order to understand that appetite, let us consider just how much negative debt there is, where it is, how it works, who owns it and why. We will then consider how it all might end and whether we will ever see negative-yielding debt in the US.
Globally, there is around $12.5 trillion of debt offering subzero yields, but that number stood as high as $17 trillion just a few months ago. The debt is present in 19 different countries, including a number of European countries and Japan. Over 90% of the total amount is government-issued debt. The corporate bond market, with a little over $1 trillion of debt trading with negative yields, represents just a small portion of the total outstanding.
Negative-yielding debt is not issued with a negative sign in front of its coupon, which would, in effect, have the lender paying a coupon to the borrower. Rather, it is issued with a zero or slightly-more-than-zero coupon, with a selling price that is higher than the face value amount. JP Morgan provides this real-world example: A 30-year German bund was auctioned in August 2019 with a coupon of 0% and a face value of €100. At the initial auction, the bond sold for €103.61. As the price of the bond was greater than its face value, the bond effectively traded with a yield of -0.11%.
Owners of the debt tend to be those looking to make a profit, those willing to pay a price for a safe asset that protects most of their principal or those who are, as JP Morgan puts it, forced owners. The first group holds the debt in hopes of profiting from price appreciation but do not hold the securities to maturity. These investors, such as hedge funds and investment funds, buy the negative-yielding bonds assuming overall market yields will fall further, lifting the price at which they can sell the debt. If price appreciation exceeds price paid, they lock in a profit. The second group, those looking for safety over return, may be scarred by 2008’s global financial crisis, making them willing to accept a loss because they desire the liquidity and reliability that high-quality debt provides. The last group, the forced holders, includes central banks, the domestic banking sector and other financial corporations such as pension funds. These buyers buy for reasons other than profit, such as a large financial institution that is required to hold high-quality debt to meet capital requirements set by regulators or central banks that buy their own country’s debt to achieve asset purchase targets. As of September, Japan owned 48% of its own outstanding government debt, while the eurozone owned 21% of its debt. Large investors such as pension funds, financial institutions and insurers may have few other safe places to store their wealth.
How does it end? No one is quite sure, but Ned Davis Research presents three possible scenarios: (1) Global growth resumes, lifting global yields in turn, once uncertainties such as Brexit, the US/China trade dispute, etc., get resolved. (2) Those countries experiencing negative rates implement meaningful fiscal stimulus, sparking growth that pushes rates up. (3) The negative rate world continues, with rates staying around zero or slightly negative for years. In this case, not the optimal scenario, monetary policy would become increasingly less effective.
Finally, will we see negative rates in the US anytime soon? The lowest level our central bank, the Federal Reserve, has cut its benchmark rate, the federal funds rate, was to the range of 0 – 0.25% during the throes of the 2008 credit crisis. As the jury remains out on the effectiveness of negative rates as a policy tool and given some significant drawbacks such as the squeeze on bank profits and the harm caused to savers, it would seem unlikely that the US Fed would embark on that path if it can avoid it. Instead, it may first lean on other tools from the past, such as expansion of its balance sheet to stimulate growth, if needed. JP Morgan points out, though, that even without the adoption of a formal negative rate policy by the Fed, it is not impossible for US Treasury yields to fall below 0%. If the Fed feels it necessary to push rates down near zero and restart its bond-buying program, yields across the US Treasury curve would fall. If this is combined with a weak outlook for the economy and for inflation, the resulting forces could be strong enough to drive Treasury yields into negative territory.
Tammy Vargo, Portfolio Manager
Bill Few Associates, Inc.
Sources: Bloomberg, JP Morgan and Ned Davis Research