Chat with the CIO: Heading to Negative Territory?

While we have been watching international fixed income markets move towards negative rates, is it possible the U.S. will follow suit?

In this quarter’s Chat with the CIO, Eric P. Leve, CFA (Chief Investment Officer) and Linda M. Beck, CFA (Director of Fixed Income) discuss the likelihood of ultra-low or negative rates in the U.S.

March 31, 2020

Eric P. Leve, CFA: We have been watching international fixed income markets move to negative interest rate monetary programs. Negative rates were first used in Denmark and Sweden in the years after the 2008-2009 Great Financial Crisis (GFC), and then became more widespread as the European Central Bank (ECB) started charging -0.10% on deposits in 2014.

When interest rates are negative, it creates an upside down world where, instead of savers being rewarded and borrowers paying money, savers are penalized and borrowers get paid to borrow money. In Denmark, individuals can now even originate negative interest mortgages. This means homeowners in Denmark pay back lenders less money than they borrowed! Although this sounds appealing to individuals with mortgages, negative yields place a strain on investors dependent on positive returns from bonds, including retirees. Linda, can you remind us how (and why) a bond could have a negative yield?

Linda M. Beck, CFA: Remembering the inverse relationship between a bond’s price and its yield, an investor would have a negative yield if he or she paid more for a bond than the combination of its face value (relative to par value or 100) and the total amount of interest paid over its remaining life. In this instance, the investor loses money over the life of the bond. Here is an illustration of a positive and negative yielding bond:

1. Positive yield: Pay $103 for a one-year Treasury bond with a 4% coupon payment. This investor would receive an approximately 1% return over the life of the investment.

2. Negative yield: Pay the same $103 for a one-year Treasury bond, but with a 1% coupon. This investor would suffer an approximate -2% loss on the investment.

It is not uncommon for investors to pay premiums for bonds, and it can frequently be a prudent move because the coupons are so much higher than yields. In the municipal bond market, 5% coupons remain the standard even though yields have not been that high for 20 years. Even when bonds are first issued, investors must pay a premium to purchase them. Buying premium municipal bonds also offers investors protection against the IRS’s Market Discount Rule. Explaining this rule is beyond the scope of this article, but it essentially reduces the tax advantage of municipal bonds if they are purchased in the secondary market at a discount. Buying bonds at a premium provides investors with a cushion before the bond’s price would fall below 100 (thus becoming a discount).

Historically, it has been extremely rare in the U.S. for prices to become so elevated that yields turn negative.

Eric: We’ve seen central banks around the world move to negative rate policies as a way to boost economic activity. Theoretically this would encourage banks to lend or invest excess funds rather than pay the penalty on the cash held in central bank accounts. Monetary authorities in Europe moved to a -0.10% rate in 2014 to fend off the risk of deflation, as well as to promote growth that had been languishing since the GFC and ensuing recession. The European Union’s (EU) difficulty in coordinating a fiscal response increased the need for monetary stimulus. Europe’s negative rate policy was then soon followed by Japan, which was trying to avoid falling back into the stagflation environment that had plagued it for the two prior decades.

The negative rate programs were supposed to be temporary, and used to prevent a deflationary spiral of weak spending, dropping prices, falling economic growth, and deteriorating profit margins. However, most countries have not had strong enough economic growth since then to work their way out of the negative rates. In fact, levels have become increasingly negative with the ECB’s official rate currently at -0.50%. Because the official rate is a benchmark for all borrowing costs in the EU, the negative yields began spilling over into other government and corporate bonds. There are now approximately 500 million people living in a negative rate environment. Total negative-yielding debt had peaked last year, in August, at a staggering $17 trillion, more than 28% of the global debt market.

So Linda, with the Federal Reserve’s (the Fed) recent dramatic move to a near-zero Federal Funds rate in response to the coronavirus crisis and the massive economic shutdown, do you think the U.S. will also go negative?

Importantly, negative rates have often led to perverse incentives.

Linda: The Fed has communicated it doesn’t believe a negative Fed Funds rate would be beneficial for our financial system. Although it is difficult to determine exactly the full ramifications of a negative rate environment, many economists and members of the Federal Reserve believe it can be detrimental to the financial system, particularly if such policies persist for long periods of time. Even the ECB, which had a -0.50% rate before the crisis, chose to not yet make their rate more negative in response to the current crisis.

Importantly, negative rates have often led to perverse incentives. European banks have been hesitant to pass along the full negative charges assessed by the ECB to its depositors. Since banks did not pass through the full negative rate costs to their deposit base, some interest margins declined and profits were squeezed. This caused banks to raise fees and/or look for other ways to boost earnings. These indirect costs add to borrowing costs, offsetting some of the stimulus aimed by the negative rate policy. Negative rate policies can also erode the capital position of banks, which in turn can lead to higher borrowing costs. This is a path the Fed would prefer not to take.

Now that the Fed is close to its zero bound, it has focused on other extraordinary measures rather than engaging in a negative rate policy. Many of these tactics were also used in the GFC. The Fed has returned to employing a number of weapons in its arsenal, including buying massive amounts of Treasury and mortgage-backed securities, engaging in repo operations, encouraging banks to borrow at the discount window, buying top tier Commercial Paper from issuers, providing liquidity to money market funds (including top-rated commercial deposits and municipals), extending dollar liquidity to foreign central banks, providing a funding backstop for some investment-rated corporate bonds, and creating a special purpose facility to purchase corporate bonds and corporate ETFs in the secondary market. All of these measures were created to promote bond market liquidity and preserve the smooth functioning of the bond and credit markets.

Eric: So if the Fed keeps the official funds rate at zero, does that mean we won’t see negative rates on our shores?

Linda: The Federal Funds rate is the benchmark rate for all borrowing costs, so having a zero negative bound does help keep other instruments from dropping into the negative yield territory. However, there is another force that can drive rates below zero: the secondary market, where prices adjust according to supply and demand. When demand exceeds supply, it can drive prices high enough to cause negative yields in some cases. In the rush to short-maturity safe assets during March, prices for some Treasury bills increased by so much that yields became negative on March 18 and stayed negative for approximately a week (at which point they returned to slightly positive through quarter-end). The negative yields occurred on the short maturities: Treasury bills with six months or less to maturity. This has happened for limited periods in previous times of distress as well. Most bonds that have credit risk, such as municipal or corporate bonds, typically trade at higher yield levels and are less likely to be pushed into negative yields. In fact, in the recent market environment, credit spreads have widened out such that securities are offering more attractive values than they have for many years.

However, there is another force that can drive rates below zero: the secondary market, where prices adjust according to supply and demand.

Eric: Thanks for a fascinating discussion, Linda. Insightful, as always! While we share the perspective that the likelihood of negative interest rates may not be increasing, it will no doubt be interesting to monitor both the actions of the Fed and the reactions of the market.