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Column: Negative interest rates—say what?

Money & Investing by Don Gould

If you’ve perused a bank statement recently, you’ve probably noticed the near disappearance of any interest income on your savings.

On a quick visit to the Chase Bank branch on Indian Hill Boulevard, we learn that the bank currently pays an interest rate on liquid savings accounts of between 0.01% and 0.09%. With the magic of compound interest, at 0.01% your money will double in just 6,932 years.

And yet, it could be worse. In many parts of the world, interest rates are negative, that is, less than zero. It’s hard to wrap one’s head around the concept, but a negative interest rate does indeed mean that, for example, depositor Sally pays her bank to hold her money.

A 10-year German government bond currently carries an annualized yield to maturity of  negative 0.69%. An investor would need to put up 10,716 euros to buy that bond today in order to receive 10,000 euros at maturity in 2029. And the investor would receive no interest along the way, so buying and holding this bond to maturity guarantees a loss. More than $17 trillion worth of bonds worldwide now carry negative rates.

In another example, Jyske Bank, Denmark’s third largest bank, now offers a 10-year mortgage at an interest rate of -0.5%. You read that right. They accomplish this by reducing the principal balance each year an extra 0.5% above the amount of principal repaid by the borrower.

Why are interest rates so low? Three primary factors drive interest rates: (1) the economic outlook; (2) inflation expectations; and (3) central bank policy (in the US, that’s the Fed). Of the three factors, the economic outlook is the most important because, to a large extent, it drives the other two, and right now all three are pushing rates lower.

Currently, most see rising odds of recession in the next year or two, which dampens the appetite for borrowed money. For example, a business that foresees a downturn in customer demand is less likely to borrow money to build a new plant. If the economic outlook gets sufficiently bleak, interest rates can even drop below zero.

But why would a bond investor or a bank depositor (in other words, a lender) ever accept a zero or even negative return on investment? Think about it this way. Most households like to keep at least some money in a reserve for the so-called rainy day. That money must be kept in a very safe and conservative place, such as a bank CD or a money market fund. The top priority on this money is not return on investment but return of investment. If market interest rates are zero or less, that’s the price of safety. The same holds true for investment portfolios, almost all of which allocate a meaningful portion to lower risk assets such as bonds and cash.

You might say, well, if I must pay my bank (or government) to hold my cash, then why not just hold it myself (in, say, $100 bills) and pay nothing? The answer is that for all but the smallest amounts, it’s not feasible. Cash balances around the world total in the trillions. That cash must be both safe and easily transferable. Neither the space under a mattress nor even the world’s biggest safe deposit box will meet that test.

And if you want to get a little wonky, there are circumstances when a negative interest rate on a bond could actually be a good deal. Consider an environment of deflation, that is, falling prices. For example, if prices are dropping at a rate of 3% per year, an interest rate of -1% would represent a positive inflation-adjusted rate.

To see how this works, suppose you have $10,000 today and you invest it at -1%. One year from now you will have $9,900. However, you would only need $9,700 a year from now to buy what $10,000 buys today (since prices will have dropped 3%). So, in our example, $9,900 a year hence represents an increase in purchasing power versus $10,000 today. In bond-speak, that’s a “real” return of about +2%.

That’s not today’s situation, however. In fact, in many cases interest rates are below inflation—a challenging situation for any long-term investor.

All is not lost, however. Despite a sizable drop in recent months, US Treasurys still pay positive interest rates that are among the highest of the developed economies. A 13-week US Treasury bill currently pays at a 1.98% annual rate (and its interest is exempt from California income tax!) For a more convenient solution, Fidelity Investments offers its Treasury Only Money Market Fund, which is paying about 1.75%, with no minimum and free check writing. Investors in high tax brackets may do better still on an after-tax basis with a tax-free municipal money market fund. Granted, the yields are low by historical standards, but they’re a lot better than 0.01% or negative rates.

And for anyone looking to borrow money, including those buying a home or refinancing a mortgage, low interest rates are something of a bonanza.

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