Negative yielding debt has ballooned over the last few years. What are negative interest rates, why do they matter, and what do they mean for investors?

First things first: What are negative interest rates?

Let’s start with “interest rates” in general, which is just another term for the cost of borrowing. Interest rates are set by central banks around the world—you can call them “policy rates.” These policy rates flow through to virtually every other interest rate in an economy, ultimately impacting the borrowing rates for businesses and consumers.

To take this a step further, central banks tend to lower interest rates to make the cost of credit cheaper and stimulate the economy (when growth is poor), or raise interest rates to make the cost of credit more restrictive and slow down the economy (when growth is at risk of overheating).

It might sound odd, but negative interest rates, while newer to the economic ecosystem, still follow this framework.

In the wake of the Global Financial Crisis, central banks around the world cut rates to emergency low levels to support their economies. And while economic conditions are certainly better now than then, global growth has been slowing over the last 18 months and inflation remains below many central bank targets. In this vein, by lowering policy rates, even if further into negative territory, central banks are trying to spur businesses and consumers to borrow and invest rather than save, and by extension, stimulate the economy.

We’d also note that when considering real interest rates (nominal rates minus inflation), negative interest rates don’t look all that uncommon. Said differently, economists often view the world through the lens of real rates (in the context of both growth and inflation), and from this standpoint, we’ve had many periods in history with negative real rates—even in the U.S.!

Nonetheless, we will focus the rest of this piece on nominal policy rates.

Got it, but what do negative interest rates actually mean for savers and borrowers?

Negative policy interest rates come with more ramifications than just low, positive policy interest rates do.

Let’s start with savers. A lot of us likely have savings accounts (or at least, I hope we do). In an economy with positive interest rates (even if they are low), savers earn interest in their deposit accounts. However, with negative interest rates, savers are actually charged for keeping money in the bank. Going back to the framework before, this is meant to disincentivize consumers and businesses from saving—in other words, central banks are saying, “Don’t hoard!” However, as it stands now, only a handful of commercial banks have started to pass on the cost of these negative interest rates to retail clients. Nonetheless, if saving becomes too punitive, this brings us to the other side of the balance sheet with…

…Borrowers. With negative interest rates, a borrower is no longer paying a reoccurring rate for money borrowed; rather, a borrower theoretically receives money to borrow. Let’s take a one-year $1,000 loan with a +3% annual interest rate, for example. In this situation, a borrower has to repay the initial loan plus another $30 to the bank in one year. However, if the loan has a -3% annual interest rate, the bank would actually pay the borrower $30 one year later for utilizing the $1,000 loan. But again, only a handful of commercial banks have started offering these rates.

What are the effects of negative interest rates?

Negative policy interest rates can make business difficult for banks. Just like for individuals and businesses, banks’ assets and liabilities are affected. In this sense, banks also get charged a negative interest rate for keeping their deposits at a central bank. However, there is the added complexity of whether, or how much, to pass on this charge to customers, for risk of deposit flight (again, as of now, most commercial banks haven’t passed on these costs). In theory, this is meant to incentivize financial institutions to boost lending to businesses and consumers.

Proponents of negative interest rates also argue that the policy approach helps to weaken a country’s currency, potentially giving an economy’s exports an advantage over economies with more highly valued currencies. In turn, this could increase import prices and help spur inflation.

Negative interest rate policy could be counterproductive should banks substantially ramp up charges and fees for customers, or reduce lending. But overall, central banks seem to be aware of the risks, deciding that the net impact is a positive one. The jury is still out in terms of research, though, as to the actual impact. There are reputable players on both sides of the debate.

So, who’s doing it?

Sweden kicked off the unconventional monetary policy practice in July 2009, and the European Central Bank (ECB) followed suit in June 2014. Other European countries (Switzerland and Denmark) and Japan have also since joined the party.

Negative interest rates: who’s doing it?

Source: European Central Bank (ECB), Swiss National Bank (SNB), Danmarks Nationalbank (DCB), Bank of Japan (BOJ), Bloomberg Financial L.P. Data is as of October 31, 2019. Policy rates are the following: ECB refers to the deposit facility rate, SNB refers to the policy interest rate on sight deposits, DCB refers to the certificates of deposits rate, and the BOJ refers to the short-term policy interest rate on current accounts.

 

Map shows that five years after negative interest rates first appeared, most of Europe still has them in place, including the countries that share the common currency.
This trend of negative interest rates has resulted in a massive build-up in negative yielding debt. Take the Bloomberg Barclays Global Aggregate Bond Index, for example. Four years ago, in November 2015, negative yielding debt in the index had a market value of about $4 trillion. That number is now about $12 trillion, though it’s come off the boil from earlier this year.

Negative yielding debt remains at high levels

Bloomberg Barclays Global Aggregate Negative Yield Debt Index, USD trillion Source: Bloomberg Financial L.P., Barclays. Data is as of November 14, 2019.
Chart shows Global aggregate negative yield debt index in USD from 2015 to 2019.

Why does it matter now? What’s being done to lessen the side effects?

With global growth slowing and central banks around the world easing policy in a coordinated fashion, some central banks have decidedly cut interest rates for the first time in years. This means that, for some economies, negative interest rates are becoming even more negative, increasing pressure on banks to adapt. To top it off, some have even started to wonder if negative interest rates are coming to the U.S. (hint: we don’t think it’ll happen).

To work against some of the adverse effects of negative interest rates, a few central banks—namely Switzerland, Japan and the ECB—have employed a program called “tiering.” Under this approach, central banks exempt some, but not all, of banks’ excess reserves from deposit charges. Most economists estimate this will go to mitigate, but not entirely offset, the impact of negative interest rates on banks’ margins.

What does it mean for investors?

In a world starved for yield as it is, negative interest rates don’t make it any easier. Investors are often faced with a choice of taking more risk and/or illiquidity to get a positive return—particularly as many euro-denominated government bonds and liquidity funds also carry a negative yield. As such, diversifying fixed income remains a core yield strategy, especially in a world of low default rates. In this sense, we see value in European bank debt and corporate hybrids. Over the last 10 years, European banks have built up high levels of capital, and credit investors have been rewarded with far greater protection than in the past. While we aren’t keen on bank equities, credit is a favored place to be, in our view.

But there are places in equities where investors can unlock yield, and Europe in particular offers attractive dividends. One of our preferred markets is Switzerland, which is defensive in nature. The Swiss Market Index (SMI) offers a 3% dividend yield, and almost 40% of the index is weighted towards healthcare companies and another 20% towards consumer staples.

Real assets can also be a manner in which yields are diversified. For example, low interest rates make for a lower opportunity cost of owning a non-yielding asset like gold, and we think adding the commodity to portfolios can help lower overall portfolio risk and improve risk-adjusted returns. An optimized currency allocation can likewise preserve long-term purchasing power and even enhance returns.

Moving down the liquidity spectrum, we think there’s an opportunity for alternative investments across private credit, real estate and infrastructure. Regulatory and structural dynamics have increased the demand for capital from non-traditional lenders, including private credit and direct lending. Lastly, on the other side of the balance sheet, modest borrowing at such rates could help boost returns.

The *Swiss Market Index (SMI)* is an index of the 20 largest and most liquid stocks traded on the Geneva, Zurich, and Basel Stock Exchanges. The index has a base level of 1500 as of June 1988.

The *Bloomberg Barclays Global Aggregate Index* is a flagship measure of global investment grade debt from 24 local currency markets. This multi-currency benchmark includes treasury, government-related, corporate, and securitized fixed-rate bonds from both developed and emerging markets issuers.