Negative Interest Rates, Part Two
January 23, 2020
In December, we discussed how interest rates in developed economies are at or near record lows, with many in negative territory (Negative Interest Rates, Part One). In this sequel, we focus on investment decision making in these interesting times.
Why would anyone buy a bond with negative interest?
The short answer is that they have no choice. Since the financial crisis, regulators have required that banks hold significantly more government debt than in the past. Other institutions may have choices, it’s just that they aren’t any better. Imagine a European insurance company with billions to invest, much of which needs to be in ultra-safe vehicles. In lieu of buying government bonds at today’s negative interest rates, that company would have to pay a fee for the privilege of depositing it at a bank. Stashing billions of cash in a bank vault (or under the metaphorical mattress) is clearly not practical (nor free). Moving beyond the private sector, central banks have been the largest buyers of government and corporate debt over the past six years, employing a monetary policy tool intended to create liquidity and grease the wheels of the economy. And these institutions are certainly not worried about the interest rate they are receiving (in many cases, paying)!
What do low rates mean for the rest of us?
Fixed Income - US savers who are currently receiving low (or no) yield on their bank accounts, CDs, and bonds are clearly not happy. Bear in mind, however, that current inflation is also relatively subdued, partially offsetting the pain of paltry returns. While we have come to understand that developed country demographic and economic realities portend continuing low interest rates, we expect that normal market fluctuations will from time to time present opportunities to invest in bonds at higher yields than are currently on offer. Accordingly, we favor buying shorter maturity bonds (less than ten years) and looking for special situations where a willingness to invest in a specific credit or a longer maturity should be rewarded.
Stocks - It’s commonly believed that stocks as an asset class should be worth more when interest rates are low. When valuing a business by calculating the present value of its future cash flows, the interest rate is a critical input – a lower rate gives rise to a higher present value. That’s all good, but what many forget is that low rates are typically accompanied by slower economic growth, lower corporate earnings, and lower future cash flows. Thus, the interest rate and other critical variables tend to offset each other. A valuation model must use assumptions that are internally consistent – we think many analysts are using today’s low rates -- without adjusting for muted economic growth -- as justification for assigning lofty price targets to some of today’s most popular stocks (which are almost all in the US).
Looking across the world, it’s clear that there’s much more to stock valuations than low interest rates. Europe and Japan have lower rates and lower stock multiples than the US. We would interpret any further compression in US interest rates as a signal of renewed recession concerns (like those that are perennially present in other developed countries) – not a time to be overexposed to stocks.
In defense of diversification
Stock dividends may be valued as a source of income, but stocks are inherently riskier than bonds and cannot prudently be substituted for fixed income securities. Balanced portfolios are still the most appropriate choice for those seeking protection against serious impairment from falling stock prices. And, when a portfolio is distributing or expected to begin to do so in the foreseeable future, maintaining some balance is a must, even in today’s low interest rate world.
Negative interest rates bring added uncertainty to an already uncertain world. They are a new concept for today’s investors, us included. The many ramifications are not fully understood, and we expect numerous opportunities to be presented to the patient, thoughtful investor.