Writer’s Block, Low Interest Rates and Baby Boomers

With the Euro Crisis continuing to dominate financial markets I have struggled to find a topic to write about other than the crisis. However, there is one area of the market where something very peculiar is happening—interest rates.

It is no secret that since 2007/08 interest rates on everything from CDs to AAA rated government debt, and even mortgages, have been low and steadily declining. This is largely due to central banks trying to stimulate growth through cheap capital by setting short-term rates at or near 0% and lowering long-term rates through quantitative easing.

However, over the last several months, nominal interest rates (or the interest rate before accounting for inflation) on bonds issued by Germany, Finland, Denmark, Switzerland, the Netherlands and Austria have all gone negative. Negative nominal rates mean that investors are literally paying the issuing country to hold their money:

“Germany sold two-year bonds at a negative yield for the first time on record on Wednesday, as the borrowing costs of Europe’s more creditworthy nations were driven even lower by investors seeking safety.” Source: Financial Times

Figure 1: Negative nominal rates on the 2-Year Swiss Bond; source: Bloomberg  

Negative yields are nothing new. Whenever the rate of inflation is greater than the interest rate on a bond or CD, the “real” rate of return on that bond is negative. For example, if you own a bond that pays an annual coupon of 2.5% and the annual rate of inflation is 3.0%, then the real rate is -0.5%—every year the value of the payment received is less than the amount that inflation has eroded. However, what is new is that for the first time ever nominal rates across multiple countries and maturities are negative.

So why would any rational investor pay a country to lock in a guaranteed loss? It doesn’t make sense, unless…

1. Investors are more concerned about the return (preservation) of their capital than the return on their capital and are therefore willing to accept extremely low rates to “guarantee” that their cash is for the most part protected.
2. Investors are using safe-haven bonds as a hedge and are counting on bond appreciation as rates go down to offset losses in other areas of their portfolio.
3. Investors expect deflation in the future, where the future value of cash is greater (i.e. buys more goods and services) than its current value. 

All of the above are possibilities:

• Greek and Spanish investors are in a situation where they are uncertain of which currency their cash will be valued in the future should their country exit the EZ. For example, if Greece goes back to the drachma, then Greeks should be willing to pay to ensure that their cash stays in Euros rather than being converted into a significantly devalued “new” Drachma.
• Other investors may be using the negative correlation to equities historically associated with bonds from AAA-rated “safe-haven” counties as a way to hedge risky assets in their portfolio. As rates decline in times of market stress, the price of their bond holdings increase (as bond yields go down, bond prices go up). By not holding the bond until it reaches maturity these investor can trade in and out of their position and lock in profits as their bond holdings appreciate.
• Finally, others may be worried that the world is entering a prolonged period of stagnant global growth similar to what Japan has experienced over the last several decades, and therefore are betting on deflation and prolonged low rates. 

Record setting low nominal yields are likely the result of a combination of the above depending on who the investor is and where he/she is domiciled. As long there is uncertainty over the EUR and global growth the trend should remain in place (particularly if Japanese-style deflation turns out to be the correct thesis). However, in theory, at some point investors, particularly income-sensitive investors such-as pension funds, retirees and banks/insurance companies, that rely on income from their investments to survive, will shift out of low yielding safe haven bonds into higher yielding securities like dividend paying stocks, such-as utilities and telecoms, and high-yield bonds.

This is particularly true given that over the next decade or so Baby Boomers will be retiring at an accelerating pace. In what may be one of the Boomers’ last rebellions against the status quo, they may stray from tradition, which would have them switching from equities to bonds as they enter retirement, and instead do the opposite in search of return and yield that offers the regular payments required to live without a steady paycheck. 

Figure 2: Investors are shifting out of equity funds into bond funds. We will be watching for this trend to reverse and for interest rates to rise as a signal that investors are reversing their conservative stance. Source: Morningstar 

Bottom Line: While very low to negative nominal rates work for a short period of time as a strategy for parking money, it is not an effective long-term strategy for many investors unless there is outright deflation. Furthermore, if/when rates increase, investors will be in for a rude awakening as their bond holdings decrease in value (interest rates up --> bond prices down). As a result, we are watching fund flows (see figure 2 above) as well as interest rates for signs that investors are tiring of playing it safe and are willing to accept more risk in order to meet their income and return objectives.

As we stated in our last commentary: “Everyone knows that Greece is in trouble. What is unknown is how individuals and banks in more economically significant countries will react to Greece’s eventual exit.” Now we can add everyone knows that Spain is in trouble, and it appears that we are getting a better idea of how investors are preparing for a possible Greek or Spanish exit—they are parking cash in traditional safe havens despite the costs.

Until there is more clarity on how Europe is going to resolve the Euro crisis, we continue to maintain our conservative stance, which underperformed in the first quarter of the year as markets ignored Europe’s troubles, but is now outperforming as market uncertainty rises once again. This means we are:

• Avoiding European markets 
• Fully invested in safe-haven fixed income assets like US treasuries, as well bonds that will benefit from further quantitative easing like mortgage REITs 
• Underweight equities by investing in ‘safer’ large, dividend paying US equities, while shorting more risky emerging market equities, which will be negatively impacted by slowing global growth 
• Underweight commodities that will be negatively impacted by slowing global growth (energy and materials) 
• Short EUR versus long USD, and at the same time long Gold as a hedge against rapid appreciation of the EUR in the event that the US Fed eases further or the EUR crisis is quickly resolved 
• Adjusting risk exposure as needed by going long or short volatility products like VXX--long volatility protects against sharp moves downward while short volatility increases exposure

To learn more about bonds read “Everything You Need to Know About Bonds” by PIMCO.