Negative Interest Rates and What They Mean to You


August 25, 2016

You may have heard about negative interest rates in the media and wondered how they might affect your portfolio. In simple terms, when interest rates are negative, it means that instead of receiving interest on your deposits, you must pay the bank to hold your money. Sounds shocking, right? The reality is that market forces are driving rates below zero in more countries around the world. While highly unlikely, only time will tell if the United States goes there as well.

What causes negative interest rates?

Although not without exceptions, the typical economic cycle drives interest rates up during expansionary times and down during recessionary times. Central banks like the Federal Reserve (the Fed) or the European Central Bank (ECB) reduce interest rates to stimulate growth. The rationale behind this is that businesses and individuals will increase spending when interest rates are low, thus stimulating the economy.

But economic growth has been slow since the 2008 Financial Crisis. This led central banks to keep interest rates low instead of increasing them in the post-recession period. In fact, the U.S. Federal Funds rate has been not far above zero for quite some time, a phenomenon exhibited in many countries. When market expectations around the world are that rates are unlikely to rise anytime soon, investors seeking alternatives push prices of government bonds higher and yields lower. The result can be negative yield to maturity for purchasers of these bonds.

This is a global issue

The week of July 18, 2016, The Wall Street Journal reported: “Germany sold 10-year bonds at a yield of minus 0.05%.” But they won’t pay any annual interest payments, given the 0% coupon. If an investor chooses to hold the bond until maturity, it will also pay back a smaller principal than was originally lent to Germany. The only way investors can make a profit on these bonds is if the price of the debt increases in secondary markets and the investor sells to lock it in.

Switzerland became the first country to sell negative-yielding 10-year debt in April 2015. On July 20, 2016, they raised another 131.5 million Swiss francs ($133.7 million) in bonds that will mature in 2058 at a yield of minus 0.023%.

Domestically, yields on U.S. Treasuries are incredibly low, as compared to historical averages. This brings up the possibility, albeit unlikely, that rates could go negative in the United States.

The Case for Value Investing

We believe that you pre-pay for expectations in growth stocks, whereas value stocks have already been discounted. This is why over the long-term, growth stocks have trailed value stocks, returning an annualized average of 9.4% while value stocks have returned an annualized average of 13.6% over the same time period.

Download The Case for Value Investing

What does this mean to you?

Many investors rely on income from their fixed income portfolios to maintain a comfortable lifestyle. After all, government bonds are perceived as a high quality and reliable source of income.  Portfolios are often heavily weighted with government bonds, and the yields of some have recently been trending downward. The good news is there are other options to generate income such as corporate bonds, real estate, ETFs, alternative investments and dividend-yielding common and preferred stock.

As you can see in the charts below, Germany, Japan and Switzerland government bond yields have been trending downward since 2004, with negative interest rates as of August 16, 2016. On the other hand, the S&P 500 annual dividends per share has been trending upward since 2004.

Bond yields have been steadily decreasing over time

 

S&P 500 Dividend per share has been increasing steadily for yearsThe reason for using dividends per share, instead of dividend yield, is that corporations have the ability to increase or decrease their dividends, whereas fixed income investment interest payments are generally fixed. The table above shows the increases or decreases in dividend income an investor in the S&P 500 (you cannot invest directly in an index, an investor would have to use an index fund or ETF representing the S&P 500, or purchase all 500 stocks) would have experienced. It’s important to note that the principal value of a stock investment, the price per share, is more volatile than the principal value of a bond investment. Upon a sale, an investor could receive more – or less – than the amount originally invested. With government bonds, an investor will generally get back “par value if held to maturity,” while the value of the bond also fluctuates along the way. A bond investor always has the option of attempting to sell prior to maturity to attempt to avoid accepting a loss.

Unfortunately, as we have posited in the past, the only hard part about timing the market is getting the timing right.  This applies to bonds as well, so if the opportunity doesn’t present itself to sell these at a profit prior to maturity, he or she will only receive back their principal. On the other hand, a long-term investor can collect dividends on their stocks (dividends cannot be guaranteed), with the yield currently 2.1% for the S&P 500 (again noting that it is impossible to invest directly in an index). Although appreciation can never be guaranteed, over the long term, stocks as a whole tend to outperform bonds.

David A. Levine offered the following in his February 12, 2016 “Your Money” commentary for The New York Times: “Looking at rolling 30-year periods, stocks have always outperformed Treasury bills and intermediates, and have only rarely underperformed long-term Treasuries.”

The average percentage that stocks outperform fixed income investments

As you are deciding how to respond to dropping interest rates, stocks should be one of your considerations in a diversified portfolio. We recommend you seek the advice of a Registered Investment Advisor (RIA) as you plan your financial future.

The Case for Value Investing

We believe that you pre-pay for expectations in growth stocks, whereas value stocks have already been discounted. This is why over the long-term, growth stocks have trailed value stocks, returning an annualized average of 9.4% while value stocks have returned an annualized average of 13.6% over the same time period.

Download The Case for Value Investing

__________________

Performance and characteristics of both stock and bond securities are subject to risks and uncertainties.

Nothing presented herein is, or is intended to constitute, investment advice, nor sales material, and no investment decision should be made based on any information provided herein. The information provided reflects AFAM Capital, Inc.’s views as of a particular time. Such views are subject to change at any point and AFAM shall not be obligated to provide notice of any change.

Any forward looking statements or forecasts are based on assumptions and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision. While AFAM has used reasonable efforts to obtain information from reliable sources, we make no representations or warranties as to the accuracy, reliability or completeness of third party information presented herein.

No guarantee of investment performance is being provided and no inference to the contrary should be made. There is a risk of loss from an investment in securities. Payment of dividends cannot be guaranteed. Past performance is not a guarantee of future performance.

287-AFAM-8/23/2016

 

MENU