I
So here’s the deal. You give me $10,050 today and I will pay you little or no interest. After five years, I will give you back $50 less or $10,000. Additionally, the interest payments you will receive will not be enough to compensate you for difference of the initial amount you paid and what you will receive upon maturity. That sounds crazy but 25% of the world’s government bonds, and many corporate bonds are currently paying a negative yield. For example, many Germany government bonds (bunds) are priced so that if the investor held them to maturity they would receive back less than they paid for the bund, including the interest payments they received. In other words, a negative interest rate.
The great recession of 2008 almost became the great depression of 2008. Financial institutions which provide the capital flows to our economy are dependent upon seized up. The Federal Reserve (and other Central Banks) took immediate and drastic steps by flooding the world economies with money by buying bonds from the public with newly created currency. This flood of new money was intended to rescue some financial institutions and then to stimulate the economy (aka Quantitative Easing). This action probably saved our economy from disaster; and dramatically lowered interest rates.
All of this bond buying by the Central Banks increased demand and thus drove the prices of bonds higher. Of course, as the price of a bond goes up, the dividends a bond pays are the same. So higher bond prices resulted in a declining yield to maturity to the point where the purchase price for the bond is more than the amount returned upon maturity, including interest payments. Again, that a negative interest rate.
But what are the long term effects of this flood of money? Ultralow and negative interest rates are unprecedented and there is no history to rely upon. Both the positive and negative consequences of historically low interest rates should be considered when building an investment portfolio.
II
The policies of the world’s Central Banks brought us to this point. Their actions dramatically dropped interest rates. The current yield to on the 10-year U.S. government bond, is at record low of under 2%. Similar policies in Europe have produced negative interest rates as mentioned above.
Ultralow U.S. interest rates are having some very positive results. Very low mortgage rates, for example, created demand for housing hence boosting home prices back up from the decline during 2008 recession. Higher home prices translated to homes again being valued higher than their mortgage balances. This is a good thing. Once homeowners have positive equity they are able to refinance and substantially lower their monthly bill. Additionally, corporations are able to borrow and refinance at much lower rates. This is boosting profitability and fueling a bull market in stock prices. Lower interest rates also increase the current prices of most bonds. Furthermore, the enormous government debt of the developed world has become more manageable as outstanding bonds are being refinanced at lower rates.
The panic of 2008 has becoming more of a memory instead of a legacy. But now, ten years later, where are we?
III
So what now? Can interest rates in the U.S. follow Europe into negative territory? And is that a good thing? Will the massive flow of money injected into the economy by the Central Banks to push rates to historic lows eventually lead to inflation and a rebound in interest rates? Are bonds a buy or a sell? Corporations have refinanced and issued huge amounts of new debt often to boost their stock prices thru buybacks. Is this nearing an end? What effect could this have on stock prices? And, of course, low interest rates encouraged our government to continue its borrowing spree.
As always, staying invested over the long run has worked and, I believe, will continue to work. There are a lot of great things happening and precisely predicting the future is a fool’s errand. However, one must stay alert and be ready to change with the times. For example, 20-year bonds are very interest-sensitive and currently do not offer much more additional yield than shorter maturities. A rise in interest rates would hurt the current price of longer dated bonds much more that bonds of shorter maturities. And perhaps this long bull market in stocks should cause one to review their holdings and compare current prices to fair value.
Again, one must stay alert and be ready to change with the times.