There is now around US$15 trillion of debt worldwide with a negative yield to maturity. While there has been debt with negative yield since 2014, the value of negative yielding debt has more than doubled in the last year. This is new territory for financial markets.
One of the basic concepts of debt is that borrowers pay interest to lenders. But what happens if this is reversed? Where would investors go to search for yield?
Growing concerns of slowing economic growth, trade tensions and uncertainty of Brexit is pushing central banks around the world to increasingly lower interest rates. Some are moving to negative rates – the European Central Bank first lowered its policy rate below zero in 2014, followed by the Bank of Japan in 2016.
Australians are familiar with interest rates being positive, meaning that people earn interest on their savings and pay it when they borrow money. On the contrary, negative interest rates are when the rates that financial institutions apply to people borrowing money or putting it in savings fall below zero.
Negative interest rates are intended to jump-start the economy by stimulating investment and consumer spending. This may be required if a country’s economy is experiencing low or negative growth, unemployment is too high, wages are not going up, people are not spending money, and inflation is too low.
Those most likely to benefit from negative interest rates are borrowers. This is because a negative interest rate could mean less interest to pay on money borrowed from banks, or the bank could even pay their customers to borrow money from them.
Visitors to Australia and exporters selling goods overseas could also gain. If the Reserve Bank of Australia (RBA) continues to lower interest rates, the Australian dollar is likely to become cheaper.
On the other hand, the potential losers from a negative interest rate would be the savers as they could lose money by having funds in a savings account or term deposit with a bank. In the last few years, Australia has already seen savers earning less interest due to the low-rate environment. This is particularly bad news for pensioners who rely on income from saving accounts or term deposits.
It would not be great for Australians going overseas either. With a weaker Australian dollar, buying foreign currency becomes more expensive. This may also affect importers, who buy goods from overseas.
Negative interest rate policy is distinct from negative yielding debt. Negative policy rates are when central banks charge interest for banks to deposit cash at their institutions. Negative policy rates do not mean negative yields in sovereign or even corporate debt, but it does impact lending and bank margins, which may ultimately affect yields across sectors.
Negative yields can be counterintuitive, and do not necessarily mean the investment pays a negative return. Negative yield on debt simply means that investors are paying more for a fixed income security than the net present value of that security’s future payments.
A number of factors have driven yields lower, especially in Europe. Lower growth and lower inflation expectations have kept rates low. Regulatory reforms following the financial crisis have increased the amount of government debt and cash banks are required to hold, while unconventional monetary policies have meant that central banks are also major buyers of government debt. This increased demand for government debt in the face of relatively stable supply is one of the key drivers of lower yields.
Demographics have also driven demand for debt. As life expectancies rise and retirement ages fall across the world, the amount of savings is rising as individuals and pensions prepare to fund longer periods of not working. Much of this increased saving is being allocated to assets at the lower risk end of the spectrum – such as government debt.
Pushing interest rates to below zero is considered unconventional monetary policy, and designed to drive banks to behave differently. It is not a guaranteed solution to stimulate the economy, plus negative interest rates could potentially have unintended consequences. A real concern is that low or negative rates could encourage Australians to make riskier investments in their search for yield and this could inflate bubbles in assets such as shares or property.
While there is increasing speculation that Australia will see further cuts, the RBA has indicated a negative interest rate in Australia is unlikely.
There have been predications made that the RBA may use quantitative easing, which essentially increases Australia’s money supply by buying bonds from the government or the corporate sector.
Investors should consider what negative interest rates mean for their portfolios. The low-rate environment has made achieving a set level of return increasingly difficult and may require investors to adjust their portfolio’s risk exposures.
While negative yields do not automatically translate into negative returns, as capital gains and roll yield can create positive returns if sold before maturity, investors continue to face challenges generating yield. Investors will potentially need to re-examine the trade-off between risk and return in building a fixed income allocation.
From the perspective of a diversified portfolio, investors will need to cope with the reduced ability of bonds to act as ballast against potential declines in equity allocations. As yields go lower, the amount of diversification provided by fixed income potentially declines.
For more on the impact of negative interest rates, speak to your Morgan Stanley financial adviser or representative. Plus, more Ideas from Morgan Stanley's thought leaders.