What Can Investors Do About The Negative Rates Conundrum?

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By Itziar Aguirre

Negative rates are the result of years of economic stagnation and deflationary fears. Spooked markets and heightened investor anxiety has provoked a pronounced change in long-term capital allocation strategies.

Central banks around the world use interest rates as a means to regulate monetary policy and influence economic growth. Several countries, including Japan, states in the eurozone, and Switzerland, have adopted negative interest rates, essentially charging banks for stashing their cash reserves at central banks. The intention is to encourage them to lend more, reduce borrowing costs for households and businesses, and spark more spending, inflation, and ultimately, growth. A lower interest rate paid on deposits should dissuade invasions of foreign funds, thus depressing a currency and provoking economic growth by making exports more competitive in global markets.

These nations are desperate to avoid another recession, as traditional monetary and fiscal policies do not seem to be working to stimulate their economies. So far, negative rates have succeeded in reducing borrowing costs, but that has not translated into a significant boost to the euro area. The European Central Bank predicts an anemic growth of 1.6 percent this year, very similar to the growth in 2015. With the safest investments offering historically low yields, the search for yields will become increasingly laborious. Experts are concerned officials have misjudged economic risks associated with negative rates, including declining bank profitability, currency wars, and an overall deterioration in investor confidence. Investors should stay nimble and avoid being seduced by, what can at times be, outlandish investments. Desperation can cloud judgement and cause investors to under-price credit/default risk and the liquidity of their investments.

Renewed rush to bond market setting record low yields

Numerous commercial banks own portfolios of government bonds, partly because regulators demand they keep a stock of liquid assets readily available. Once a reliable source of income, the interest payments on high-yield bonds are being replaced with much lower yields and even negative ones.

There are over $13 trillion in government bonds around the world, including Denmark, Germany, and Japan, at the moment that offer yields below zero, which means investors who purchase these bonds and hold them to maturity will not get all of their money back. As a flight to cash takes place, investors should bear in mind that while amassing cash in a portfolio will undoubtedly reduce volatility, it does not provide the counterbalancing effect in a portfolio that bonds provide when equities fall.

Negative interest rates and investment

Negative interest rates matter, as they inevitably prompt banks and other investors to buy things that are very much like money - short-term debt of ultra-safe governments and fixed income-focused exchange-traded funds (ETFs). Negative rates have different effects on ETFs. As an economy contracts and a negative interest rate policy is implemented, government and investment-grade fixed-income ETFs flourish, while the prices of high-yield bond ETFs fall.

If the negative interest rate policy accomplishes its goal of increasing lending, interest rates climb as the economy improves. In this case, an improving economy with increasing interest rates is likely to boost the price of high-yield bond ETFs, while the price of government and investment-grade fixed-income ETFs decreases.

Although the relationship between interest rates and the stock market is fairly indirect, in theory, declining interest rates should boost stock markets. When rates fall, investors are forced to look elsewhere for yield and are likely to turn to the stock market. However, that has not been the case empirically in regions that have entered the uncharted territory of negative rates. The only market to actually witness a gain since establishing negative rates has been Denmark.

Real estate investors encounter a counterintuitive quirk

Negative interest rates and record low government bond yields have provoked a pronounced change in long-term capital allocation strategies across institutional investors. This creates an arduous environment for investors looking for stability and yield, and compels them to take riskier investments. The real estate market, especially in the U.S., has emerged as one of the top safe havens for foreign capital.

However, negative interest rates have real estate investors facing an investment peculiarity. Their borrowing costs can actually increase as interest rates decline - a burden which is felt particularly by property investors who take out floating-rate loans. This is a result of how interest rate swaps are structured. Swaps are essentially financial products that are sold alongside loans, which aim to protect borrowers against rising rates. Property firms usually borrow through floating-rate loans, whose interest payments move as rates shift. Simultaneously, they buy interest rate swaps to protect against an increase in rates on their floating-rate loans. However, swaps usually don't have a floor. When interest rates go negative, the property firm has to pay the swap counterparty more, while the quantity it pays the bank stops decreasing. A cap essentially fixes its floating interest rate irrespective of whether the rate is positive or negative.

Commercial property prices have soared since the recession, and while returns for property owners are at record lows, they're still much more attractive than what investors can get from today's anemic bonds or money markets. That said, as global capital continues to saturate the market, there is a risk that property valuations become progressively stretched with regard to fundamentals.

Negative interest rates are ultimately an act of desperation. There is growing evidence that negative rates hurt bank profitability - something that could eventually cripple the stability of the financial system. Savers can expect to not only earn next to nothing on deposits, but eventually pay fees as the banks try to pass on their increased expenses and ease their drop in profitability.

However, professional money managers may find opportunities in this type of climate. For example, for those who believe that interest rates will remain low for the time being, high rates offered by some corporate and high yield ("junk") bonds are worth considering. And finally, stocks, especially those of companies that are not conditioned to macro growth concerns, still afford significant opportunities.