First Quarter 2015 – Quarterly Commentary

Negative Interest Rates (Or, now, I’ve really heard it all)

Implications for the global economy, the capital markets…and your portfolio


Hello! “Negative” interest rates? What exactly are “negative” interest rates? A fair and reasonable question to ask because, they are a phenomenon which seem to be spreading and quite possibly, coming to North America in due course.

Firstly, let’s define what “negative” interest rates are. You’re an investor and you are accustomed to purchasing a fixed income instrument (let’s say a 5 year government bond or, perhaps even a 5 year GIC). You will reasonably enquire as to what the yield will be. Twenty plus years ago, you might have been told 10%. Ten years ago, you might have been told 5%. Recently, you might have been told 1.75%. This “interest” would be paid to you either semi-annually or, at the end of the year but either way, you would be paid at that rate each year over the five years you owned the debt instrument.

In Germany today, you might be told that we will take your investment capital, of say 1000 Euros, and (effectively) we will give you back 950 Euros in five years. That’s an effective “negative” rate of return of 1% per annum. Yes, we have greatly oversimplified our example here, but it is the point that matters, which is: You, the investor, will get less capital back in five years than you are giving the borrower today. Sounds preposterous doesn’t it? Maybe, maybe not. One’s willingness to do such a transaction could be a function of ‘who’ (institution or private) you are as an investor, and one’s expectations for inflation or deflation. Put in other words, it is also all about the time value of money.

If one’s expectations are for deflation – a scenario in which your currency (dollar, Euro, Yen or, whatever) will buy you more goods and services next year or, down-the-road, the natural instinct is to hoard your cash and wait for prices to fall, in which event your effective purchasing power has gone up. If, on the other hand, your expectation is that prices will go up (inflation), the incentive is to spend your currency now for it will buy you fewer goods and services down the road.

Differing types of “negative” interest rates and their consequences

In practice, there are three types of negative interest rates. The three types of “negative” interest rates described below will manifest themselves in different ways, in different markets and different asset classes.

Firstly, there are those that are caused intentionally by central bankers wishing to prevent their currency from rising. This is usually done by the central bank charging penalty interest on deposits placed with them by the members of the banking sector. The Swiss charged foreign investors interest for placing deposits with the Swiss Central Bank as far back as the 1970s. This is an intentional act and is not particularly dangerous to the economy. This first instance is largely contained in the interbank deposit markets and is unlikely to affect the average investor.

Secondly, there is the case of central banks employing a strategy of excessive quantitative easing or good old “pump priming” in an effort to move a moribund economy into a growth spurt. In the early stages of employing this strategy, the excess cash moves into the short end of the bond market and secondary market bonds trade at negative yields. This is usually corrected over time as the cheap money moves into the real economy and real growth commences. This second instance will take place in the money markets and the secondary bond markets and will affect all investors as they struggle to earn a reasonable yield on their hard earned savings but as mentioned, will usually be self-correcting over a short period of time as cash finds its way into the real economy and promotes economic growth as intended.

In the third situation, the investing public is faced with a massive amount of cash, caused by excessive QE and is accompanied by negative demographics whereby an aging population simply doesn’t spend as it used to and a potentially severe case of deflation takes hold. There are simply insufficient suitable assets in which to invest the massive tide of excess cash resulting in negative interest rates. This is currently the case in Europe and Japan and could yet be followed by North America. This scenario gives rise to a number of asset bubbles in various asset classes, usually commodities, equities and real estate. This third type is far more serious as the central banks run out of ideas for growing the economy and a cycle of inflation/deflation takes hold.

At this point we find that the economy is harbouring numerous bubbles in various asset classes while economic growth is anaemic. The central banks are flooded with cash and eventually start charging the deposit taking banks a penalty interest in an attempt to force them to lend to the real economy. The banks, however, are unable to do this and they pass the costs of this on to the general public. Has anybody noticed the massive increase in their bank “fees” of late? This is but one way in which such costs are passed along to us. Now, we have set the cat amongst the pigeons as negative interest rates move into the primary market sphere with investors providing borrowers with more capital than they expect to have returned. This has already occurred in the Danish mortgage market, the Swiss bond market and has now spread to Germany.

This may not correct in the short term…as both expected and hoped. In fact, the central banks are faced with an unenviable situation for no matter what they do, they adversely affect economic growth and worse, they add fuel to increasingly risky asset bubbles. When these burst, as they inevitably must, the consequences may well be much worse than 2008-9. If they add to QE they are exacerbating the amount of cash on deposit at the Central banks and adding to the negative interest rate conundrum in addition to further inflating bubble markets. If they drain cash in an attempt to raise interest rates they hurt the weakest members of the economy, who cannot borrow from banks and end up in bankruptcy further depressing economic activity.

The reactions in the market place cause fiscal and monetary policies to diverge even further and could upend the monetary system as we know it today. As with the crisis in 2009, the interbank market may well dry up as liquid banks prefer to leave excess cash with the Central Bank and will not on-lend to illiquid (but otherwise sound) banks. Certainly wages will stagnate and employers lay off staff as the economy weakens. We could find (in extremis) a reversion to a form of barter system as investors develop an aversion to cash, since holding cash costs them money and buying assets today is fruitless as they will be cheaper tomorrow.

What does this phenomenon mean for governments?

Daddy, how does a government “tax” a negative interest rate? Son, I have no idea but, this I do know, they will find a way!

If savers cannot or will not save (and invest) sufficiently, does this mean that governments will have to step in and pick up the slack? Does this in turn, portend renewed upward pressure on tax rates?

And what about Institutional Investors? Pension, Endowment & Foundation Funds

It is likely life insurance companies and pension plans are the most vulnerable to low and negative interest rates. Both the liability (the need to pay a fixed investment return or benefit) and the investment return side of the business are impacted. A decline in long term interest rates increases the liabilities (the discounted value of future cash flows) to the insurance company and the pension fund. Re-investment returns in bond portfolios are negatively impacted which creates a mismatch between the longer term liabilities and shorter term assets. As lower economic growth is associated with low to negative rates, investment returns in general and equities in particular are expected to be lower. Consequently, insurance companies with high return guarantee policies and pension funds with defined benefit promises will be hard pressed to meet these obligations.

Life insurance companies are likely more adversely impacted in this situation than those that specialize in other areas of the field. These policies tend to be long term and explicit return guarantees (interest rate return) and guaranteed income (annuity) streams. Consequently, life companies tend to invest in longer term assets and will implement a hedging program in an attempt to lock in the higher rates. This introduces the concept of counter-party risk to the investment. The non-life contracts tend to be shorter term in nature and renewed frequently, and any payouts are expected to be paid in the short to medium term are more easily provided for.

For pension funds, the impact differs depending on whether the plan is a defined-benefit (DB) or defined-contribution (DC) plan. In defined-benefit plans with fixed future benefits (a guaranteed return on contributions that are not linked to either salary or inflation) the impact is greatest. With negative rates, both the funding requirements and performance suffer. Simply stated, the longer the liability, the greater the impact. Contribution rates to pension funds – especially those with low funded status – will soar because funds cannot generate sufficient income/cash flow to meet outflows, especially with negative interest rates in a fixed income portfolio. Cities like Chicago and states like Illinois are particularly vulnerable under these circumstances. Pension plan sponsors in both the public and private sectors will accelerate the conversion of defined benefit plans into defined contribution plans for current and most likely, all future employees. They simply can no longer take on the risk.

Both insurance companies and pension funds may be tempted to consider more volatile, less liquid and higher risk investments in an attempt to capture higher yields. Such behaviour may indeed intensify asset price bubbles, particularly if “herd like” behaviour becomes prevalent. The so called “search for yield” raises the possibility that absent proper consideration of risk, financial stability is possibly threatened. Even with such consideration, it is possible that with the use of interest rate hedging, activity will actually lead to a further downward pressure on interest rates. As a consequence of such activity the likelihood of increased regulatory supervision becomes a stronger probability.

For the Endowment and Foundation sector, payout rates will (continue to) decline thus negatively affecting recipient programmes and frustrating donor intentions. Like other investors, institutional or, private, low-to-negative interest rates may well cause such funds to take on enhanced and quite possibly unacceptable levels of portfolio risk in order to maintain payout ratios.


Could face increased challenges in borrowing which has adverse implications for their balance sheet. On the other hand, those with strong balance sheets which need (or seek) to borrow will be doing so at rates not seen since the 1930s, and will flow any interest savings on their debt issuance directly to their bottom line if they so choose.

Private investors:

“Savers” lose out…“spenders” win

It forces all types of investors further out the risk curve in search of returns

Without a doubt, individual investors will face equally daunting challenges if this conundrum of negative interest rates spreads let alone if it persists. As with pension, endowment and foundation funds the big challenge will be generating income if bond yields “go negative” as they have in selected countries already. What this could ultimately mean is that in order not to take on more portfolio risk than the investor ought to, encroaching on capital could be an acceptable alternative to “reaching” for returns and suffering significant capital losses. Recall always that it is the return of our capital which trumps the return on our capital. It’s just that we are increasingly being pushed (yes, by Central Banks everywhere) into riskier investment assets in search of return. This does not mean jettisoning the paramount rule of safety of our capital – especially for those who are retired and cannot replace or, replenish that capital if lost.


We do not have, nor have we offered all the ‘answers’ to this investment challenge. Rather what we sought to do with this Quarterly Letter was to raise the issue with you, our valued clients, and make you aware that we are aware of this issue which will affect us all.

We hope we have been able to convey ‘what’ negative interest rates are and, to some degree, how they are impacting the investment landscape for investors of all types everywhere.