Special to the Financial Independence Hub
Bonds are boring. They’re supposed to be.
In the relatively dry world of finance, one of the valuable functions that bonds (fixed income) provide is to increase the diversification and resilience of balanced portfolios — by serving as a fire extinguisher when times get tough, rather than an accelerant.
They’re designed to make money, but also to manage any potential sparks or flare-ups lit by their flashier equity counterparts. While no one has pulled the alarm in this new realm of negative interest rate policy imposed by certain central banks, it’s still a good idea for fixed-income investors to be aware of their bond holdings; they should check to ensure that, like a fire extinguisher kept in the kitchen, they’re still appropriate and ready to do the job they’re meant to should the need arise.
What’s happening with negative interest rates?
In 2014, the European Central Bank became the first major central bank to shift interest rates into negative territory. The central banks of Sweden, Denmark, Japan and Switzerland followed suit soon after.
Negative interest rate policy is a signal that the more traditional policy options have been ineffective; that new boundaries need to be explored in order to achieve each central bank’s individual mandates for the role they serve within each country and the broader global economy.
Up until 2014 there was no modern historical precedent for negative interest rate policy. The typical mandate of a central bank is to target a low and stable inflation rate. In theory, raising interest rates usually slows down the economy and reigns in inflation, while lowering interest rates usually increases economic growth and inflation. If inflation is positive, low and stable, the future is more predictable for businesses and individuals to plan their investing, borrowing and consumption requirements.
In theory, negative interest rate policy is intended to incentivize banks to extend loans to businesses and individuals; this increases demand for loans and therefore encourages economic growth. Whatever cash that is left over (and eligible in the banking system after day-to-day operations) is held on deposit at the central bank at negative interest rates. In essence, private-sector banks are being penalized. Until recently, this was unheard of in modern history.
Usually if you borrow money, you have to pay interest on it. This has been the foundation of our banking system for centuries. So it’s a pretty radical concept that banks have to pay the central banks in order to simply give them their excess cash balances. So far, banks have absorbed these costs and not passed on the negative interest rates to retail account holders. This ultimately can affect the profitability of the banking system and can become risky not just for banks but for the economy in general.
Falling expected returns on high-quality bonds
Negative interest rate policy, bond purchases by central banks, aging demographics, low growth, low inflation and increased uncertainty have all lowered expected bond returns on high-quality bonds. This has put pressure on investors to move further away from the familiar protection of their traditional fire extinguishers into riskier, more exotic alternatives with the hope that they may offer higher returns.
At the same time, it has forced people to think more long-term—beyond the instant gratification of buying “stuff” and more about their desired nest egg amounts. And, of course, the more money people put towards their retirement goals, the less they have to contribute to overall consumer spending. This is a powerful side effect that is an increasing threat to the main goal of negative interest policy — which is to increase demand for loans.
The world is still trying to make sense of negative interest rates. During a recent trip to Sweden I was told from the RiksBank (Sweden’s central bank) that their banking system was not designed to receive interest payments from holders of floating-rate bonds when they dropped below zero. When floating-rate bond yields went below zero the yield was assumed to be zero and the holder did not have to make a payment. This is indicative of many systems that were simply not built to incorporate negative interest rates.
Other anomalies are occurring as well. A recent article in the Wall Street Journal chronicles how one Danish couple is actually getting paid interest on their mortgage. As in Sweden, consumer savings accounts pay no interest and real estate is booming. Instead of paying interest on the loan they acquired a decade ago to buy a house, their bank paid them the Danish equivalent of $38 in interest for the quarter.
By the end of the year their mortgage rate, excluding fees, was – 0.0562%. The bank would likely recoup this loss in other ways (e.g., ATM fees and other charges), but what’s happening in Scandinavia may provide a glimpse of the topsy-turvy effects negative interest rate policies can have on the world.
What does this mean for bond investors?
So what are implications for bond investors and how tough will it be for people to reach their investment goals in this environment? Unfortunately there’s no easy answer. Ultimately, you need to choose between staying the course, recognizing that expected bond returns may be lower in the future, or abandoning ship and increasing the overall risk you’re willing to take in your portfolio in order to earn a potentially higher return.
We believe the best strategy moving forward is to keep your fire extinguisher handy, focus on longer-term investment and maintain a balanced, diversified portfolio. Whatever you decide, it’s important to be aware of your bond exposure, or lack thereof, because if you choose to increase your risk profile or not to have any exposure you could be indirectly increasing the risk of your overall portfolio.
James Redpath is Fixed Income Portfolio Manager at Mawer Investment Management Ltd., which he joined in 2010. He is the lead manager of the Mawer Global Bond Fund and co-manager of the Mawer Canadian Bond Fund and the Mawer Canadian Money Market Fund. His primary responsibilities are the research, management and trading of the Firm’s fixed income strategies.