I’m fairly certain that at some point in the future, we will look back on this period and wonder how we could have ever believed that current negative interest rates seem reasonable.
Right now, there are several trillion dollars worth of bonds issued by various nations, and even some companies, trading at negative interest rates. That is, investors are buying the bonds in the knowledge that if they hold them to maturity, they will get less money back than they paid for them. The quote below nicely summarises the situation.
“…we’ve often discussed how interest rates are the most important markets in the world. They move the other markets. And what’s happening in the world of interest rates is truly unreal…nearly every country in the world has negative interest rates (below 0%), and it’s spreading. That is, negative interest rates are rapidly going from short-term interest rates all the way out to 10-year yields and beyond. In Germany and Switzerland, the 30-year yield is negative.
So why is this important? Mainly because it’s crazy. It goes against all common sense. It literally means, for example, if you buy a 10 year government bond in a negative yield country with a face value of $1000, you’ll receive about $950 at expiration. Again, this…goes against the way the global economy is supposed to function, and the way it has functioned for over 5,000 years. This is a huge deal but since it’s never happened before, no one really knows how it’ll all end up.”
Excerpt from the Aden Report, September 2019.
Who is buying assets that can lose money?
Let’s just stop for a moment and think about what negative rates mean. Investors are happily buying assets that are guaranteed to lose money. Who would do that? Well, here are three examples of types of investors that own bonds, and the reasons they own them:
- The forced owners. They have no choice, as they are required to own bonds. Examples include banks and insurance companies. These regulated entities must hold a large proportion of their assets in bonds with a superior credit rating.
- The conservatives. They are worried and holding a portion of their portfolio in “low risk” assets that will hold their value (or go up) if markets fall. This is the case for many investors right now, particularly those who cannot risk a loss of their investment capital.
- The traders. They think that rates can go even lower and that someone else will pay them more in the future. To be fair, that has been the case for over 30 years now. But we think it is now getting close to the end of this trend.
The trend has been your friend.
That last point is the most relevant. As bond yields have fallen, particularly longer term bonds, investors have made money from the interest rate fall itself.
To demonstrate, let’s use a simple example. You buy a newly issued $100,000 10 year bond with a fixed rate of 7%, which is equal to the current market rate at that time. You hold it for a year. During that year, expectations for interest rates fall. At the end of the year, 10 year interest rates have reduced by 0.5%, to 6.5%. So, over that year, you’ve received interest at the fixed rate of 7%. In addition, your 10 year bond is now worth around 4.5% more, because it has a fixed rate that is 0.5% higher than the current market rate locked in for another 9 years. So your boring old bond has made you 11.5% in one year.
That, in essence, is what happened way back in 2009 or 2010. And since then, it has kept happening almost every year, as long term interest rates have trended lower. The have not always moved down in a straight line. But generally, they have moved downwards for the past 10 years.
The most recent episode has happened in the past twelve months. Australian ten year bonds have gone from yielding nearly 2% a year ago to an all time low under 1% a few weeks ago. So if you bought an Australian 10 year bond issued a year ago, you received interest of just 1.9%, but a capital gain of close to 9%, as the bond now pays 1% more than markets expect for the next 9 years. But, given yields are now so low, this is where it gets interesting.
Are we at an inflection point?
Ray Dalio from Bridgewater, one of the most successful investors over the last 30+ years recently released this letter. It’s an excellent piece, but a long read, so I’ll summarise. Having studied long term financial and economic cycles for the last 1,000 plus years, Ray Dalio maintains that we can observe reasonably long periods where trends are in place, followed by “paradigm shifts” where those trends change. Ray suggests that we may be reasonably close to one of those times now. The paradigm shift will be the end of ultra-low interest rates.
Why might that be? Well, let’s think about what happens from here if interest rates don’t keep falling. The annual return from that Australian ten year bond mentioned above for a buy and hold investor will be just 0.9% (before taxes and costs). For the next nine years. I don’t know too many people who are prepared to accept that level of return going forward. Certainly, the forced owners will have to accept it. They have no choice. But I think it’s fair to say the traders and at least some of the conservatives will be looking for alternatives.
Things could be about to get strange
When interest rates get this low, weird things start to happen. For example, last month, for the first time ever in my career, a bank refused to take our money. That bank, with whom we had an existing relationship, refused to open a new account because they specialise in helping customers in the agriculture sector. That’s fair enough. Because we don’t operate in that sector, and because we had no loans with them (on which they make most of their profits), they didn’t want to allow us the privilege of depositing our money with them (on which they make no profits).
If interest rates reduce further from here, I suspect this type of behaviour will become more prominent. Banks will want less money. They will start to prioritise who they take it from, and how much interest they pay. We may see them start to charge to hold cash, as we have seen from time to time in the US and Europe.
We’re already pretty much at the point where there will be minimal further mortgage rate reductions if the RBA lowers the cash rate. The banks simply cannot afford to do so, because much of their deposit base is already earning zero.
So, how will it play out?
Broadly, of course, there are three potential outcomes from here. Interest rates can fall further, they can stay close to current levels for a long time, or they can increase. Let’s explore each of those possibilities, and what it might mean for markets.
Interest rates go lower.
We believe it is fairly unlikely that bond rates fall substantially from recent record lows. There are valid alternatives to bonds and as rates fall further, those alternatives become more and more attractive. For example, instead of bonds, why not own some gold. It has no yield, but at least it’s not negative! That’s what Ray Dalio thinks might happen. Or why not just put your money under the mattress, where it will earn a guaranteed zero. Other assets which also have no yield and could become more popular include collectibles and crypto currencies. And there are a raft of asset types with low yields such as farmland and residential property which might continue to become more attractive. So, if negative interest rates do become more common, bonds simply become less and less attractive, as the appeal of other options increases.
There is one scenario in which lower interest rates make sense. In a deflationary environment, where assets continually fall in value, investors might be happy to own bonds at a zero, or slightly negative yield. This is because the alternative is to own assets that will lose even more value. We sincerely hope that’s not where we’re headed. That’s broadly the environment we’ve seen in Japan for the last 30 years and it has not been a lot of fun.
Interest rates rise.
There are perhaps two ways we could see higher interest rates. Firstly, it could happen slowly over time, as reasonable growth enables economies to withstand higher interest rates again. This would obviously be the preferred outcome, but the current signs are not that encouraging. Countries that have engaged in a lot of stimulus designed to restore economic growth, have largely found that after a period of positive impact, lower growth returns. There appears to be a law of diminishing returns at play here, where more and more stimulus has a lower and lower positive impact. Meanwhile, the cost of the stimulus, usually government deficits and increased borrowing, mean that the overall structural picture declines.
Interest rates rise quickly.
There is a second, more disruptive path to higher interest rates. It’s not clear what might start this scenario off. It might simply be that the traders and some of the conservatives will wake up and realise that the returns on bonds are unacceptable, the prospects for further rate reductions slim and the investment alternatives more appealing. And they will start to sell their bonds. It would probably start slowly, then gather pace much quicker than anyone can imagine as panic sets in. Anyone holding longer term bonds will be hurt. The longer the term of the bonds, the more they will be hurt. Traders who do not adapt quickly will suffer significant losses. Conservatives will start to panic. The forced owners will have to hold on.
In a rising interest rate environment, anyone holding shorter term high quality bonds will probably not lose money. And holding floating rate or inflation adjusted bonds will probably work out OK, as the income will adjust upwards as rates increase and returns will improve. Because returns on these assets adjust with the market, there will be no capital losses.
There would be significant flow on effects from an increase in interest rates, regardless of what causes it. In essence, we will see a reversal of returns on things that have worked well in the past. Growth stocks will likely be hurt, as PE ratios for these stocks fall. Firms with significant borrowings will be hurt as debt gets harder to come by. Property and infrastructure values will be under pressure as higher interest rates lead to higher yields being demanded and lower values. The faster interest rates rise, the more violent and disruptive these impacts will be.
Interest rates stay low.
This seems to be the most likely outcome. A long period of below average growth, and very low interest rates. The problem with this scenario is that it’s going to continue to build imbalances. Total debt will continue to increase due to cheap money and Government “fixes”. Wealth inequality will continue to grow. This can lead to further unrest and a continuation of the trend of political “extremists” having significant influence.
The other obvious problem for investors if rates stay low is that returns will be abysmal. Without the boost from rates continuing to go down, returns will be close to zero. High quality bonds will no longer be attractive. That is already leading to some riskier products emerging to combat these low returns. Examples include funds with a high proportion of riskier bonds. These can react more like equities in a market correction, which is not ideal. We’re also seeing geared bond funds emerge. These use leverage to turn a mediocre return into a half decent one. Unfortunately, such products also magnify any losses that occur.
Investors will seek alternatives to low yielding bonds in the same way they have been seeking alternatives to cash in the past few years. It could mean that growth stocks and property become even more overvalued than they already are. Our bet is that if low rates continue, the biggest beneficiaries will be some of the assets that have been under appreciated for the past few years. Value stocks, in particular, are likely to finally get a bid. Investors will come to appreciate that low PEs translate into pretty decent returns. Even if the companies are delivering very low growth. If interest rates do stay low for a very long time, then some parts of the stock market are still way undervalued. The big returns over the next few years are likely to come from these unloved stocks that can still demonstrate a little bit of growth.
Conclusion
We’re in a tricky spot. Interest rates have been driven down to never before seen levels, and investors have benefited along the way. But the ability for rates to fall further is limited, as very low or negative rates cause other assets to become more attractive. Given interest rates impact returns from almost all other asset classes, what happens to the bond markets is crucial to future investment returns from all assets.
Who knows where we go from here. Rates could fall further, with a greater proportion of bonds trading on negative yields. That seems the least likely outcome, in the absence of sustained deflation, which no-one wants to see. Rates could increase back towards long term averages. This could happen quickly, resulting in major corrections for a large proportion of investments. Or it could happen more slowly, driven by a genuine return to above average economic growth. Finally, and we think most likely, we will see a sustained period of very low interest rates and below average growth over the next 5-10 years.
If we are right, there will be few places to find above average investment returns. But a good starting point might be to finally ditch the long term/fixed rate bonds. Instead have some exposure to gold, some alternative investment strategies and value stocks. Our Affluence Investment Fund has a bit of the first one, a good dose of the second and plenty of the third. In short, it holds more of assets that are cheap, and very little of those that are not.
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