NEGATIVE-YIELDING BONDS: PAIN AND UNINTENDED CONSEQUENCES
The market for negative-yielding bonds has surged to more than USD 6 trillion, presenting a real reinvestment risk for fixed income investors. Of this total market, government bonds in major indices have rocketed from none in 2014 to USD 2 trillion in December 2015 as the Bank of Japan joined the Swiss National Bank, European Central Bank, Danmarks Nationalbank and Swedish Riksbank1. How sustainable is the trend to negative interest rates, and how far can central banks go in setting them?
By Manuel Streiff, Head of Fixed Income for private clients at Lombard Odier
Zero interest-rate floors are a deterrent to lending money and create an obstacle for central banks’ monetary policy. The supply-demand of money in the financial system is being distorted by the fact that banks cannot easily apply negative interest rates to deposits, as long as clients have the freedom to withdraw money in cash.
Studies2 in the past suggested there was a practical limit for negative interest rates of around -1%, the price large deposit accounts were ready to pay to have their money in safe and liquid bank accounts. Beyond this threshold, the risk of a bank run rises as savers look for alternatives such as paper money. Harvard economist Larry Summers wrote this year 3 that G20 countries should stop issuing paper currency worth more than USD 50 to discourage savers from piling savings into deposit boxes.
An October 2015 working paper from the International Monetary Fund 4 offers a solution through a “transitional electronic money system”. The idea is that negative interest rates include a time-varying deposit fee so that the value of paper money and the value of funds in electronic accounts move in tandem.
With a -2% interest rate on cash deposits, for instance, an investor who takes currency from a bank account to put under a mattress would only be credited 98% of their cash one year later, in the same way as if the money had stayed in an account. In other words, the value of paper money relative to electronic money would depreciate in a negative interest-rate environment, thereby eliminating the zero bound.
Still, the idea that the practical limits of negative interest rates have been reached and that the future of the fixed-income asset class is only downside risk with no return, demands a second look, and must be put in context.
Overall, we believe that there is a significant risk that central banks will move their reference rates into negative territory in order to halt deflationary pressures, even though the economic impact over the last few years has been spectacularly unconvincing.
The unintended consequences of such a structural shift shouldn’t be underestimated – particularly in light of the trillions of dollars in interest-rate derivatives anchored to floating rates such as the Libor. It’s more important than ever to assess reinvestment risk, which in a negative-yielding environment can turn the opportunity cost of failing to be invested into a concrete negative. The ‘pain trade’ is indisputably leaning towards further moves into negative territory, not higher rates.
1. Bloomberg, March 2016
2. More on the debate “Low for Long? Causes and Consequences of Persistently Low Interest Rates” – Geneva Reports N° 17; ICMB, October 2015
3. Washington Post, “It’s time to kill the $100 bill”, Lawrence H. Summers, 16 February 2016
4. IMF Working Paper (WP/15/224) – “Breaking Through the Zero Lower Bound”, October 2015
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