What are negative yields?
Last updated: 06 Jul, 2020 | 06:15 pm
Any fixed income instrument (like bonds, T-bills) usually requires an initial principal investment which it pays back with interest post a stipulated amount of time. This interest rate is linked to the borrowing and lending rates in the country which is further dependent on the inflation rate.
Sometimes economic circumstances result in the yield of fixed income instruments into the negative i.e. an investor gets a negative return on investment.
How does this happen?
- During an economic crisis, when the future is not looking bright, investors flock towards safety. Investors start putting their money in the safest instruments possible like Treasury bills. The demand for such instruments increases exponentially.
- When this happens, the price of these instruments starts rising and sometimes, due to a shortage of such instruments they go beyond their total returns.
- Further, if there’s a fear of deflation (reverse of inflation where prices of goods and services fall), the real interest rate is worth considering. Ie if investors believe there will be -5% deflation, an interest rate of -1% in a safe haven doesn’t seem so bad.
- In the US, T-bills are one such safe haven. They are backed by the federal reserve and are denominated in US dollars (considered as the safest currency in the world).
- The US fed has been continuously cutting their interest rates to promote growth and increase liquidity in the system. The short-term yields in the USA are almost 0% right now.
- As a result, T-bill auctions have been seeing record demand currently, even when a 5 year T-bill yields below 0.3%!
What’s happening across the world?
- After retreating from a peak of $17 trillion in August 2019, negative-yielding debt is making a resurgence, as central banks across the world have been cutting rates.
- Currently, over 25% of the world’s investment-grade debt have negative yields.
- Most of the large European countries like Switzerland, Germany, Netherlands, France have negative yields ranging from -0.2% to -0.7%.
- This situation hurts bank’s profitability, funds and institutions such as Pension funds(AUM >$30 Tn) are mandated to allocate large portions towards only Government-backed debt
How could this impact your investments?
- Deflation of economies is not good news. While central banks normally use interest rates to kick start growth, the effect of negative rates limits the tools that they have to stoke inflation and hence prevent the economy from falling into a recession.
- The drop globally in government bond yields is a further sign that risks are increasing in global markets. Safe debt is in a yield spiral; where investors are chasing safe instruments and in effect driving the yield further down.
- Similar behaviour is panning out in our bond markets where the difference between AAA rated bonds to AA+ bonds (One notch lower) is at a spread of 2.8%.
- We re-iterate: while riskier instruments such as non-AAA rated bonds and corporate FDs could give a higher return, we advise you to stick to AAA-rated instruments, as the safety of capital is of paramount importance in the current environment.
- With interest rates trending downward globally, expect to earn a lower interest rate on your fixed-income investments as well. Major banks in India have already slashed their deposit rates
- The silver lining in this environment is that you may benefit from lower interest rates for your loans.
Have more questions on this issue? Reach out to your personal family wealth office!