Q&A on Negative Interest Rates - Wells Fargo Investment Institute

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Q&A on Negative Interest Rates

Wells Fargo Investment Institute - March 12, 2020

Global Fixed Income Strategy Team

Investor concerns about negative interest rates have resurfaced over the past several months. Wells Fargo Investment Institute has conducted research and published an In Depth report on this topic.1 We have created this executive summary to address, at a high level, some recurring questions that we have been hearing from investors.

Are there different types of negative interest rates?

There are two main types of negative interest rates: benchmark policy rates set by central banks and the negative yield to maturity on developed market–ex U.S. government and corporate bonds.

There are four central banks that currently have negative policy interest rates: the European Central Bank (ECB), the Bank of Japan (BOJ), and the central banks of Denmark and Switzerland. The central bank of Sweden moved its policy rate from -0.25% to zero on January 8, 2020.

Approximately 70% of the negative yielding debt is concentrated in government issues from Japan, France, and Germany.2

Who buys negative yielding debt?

Central banks have remained significant purchasers of negative yielding debt as part of their quantitative easing monetary programs. Some investors have bought negative yielding issues as perceived “safe havens” during times of financial market stress.

Many institutional investors have been forced to buy these securities, despite the negative yields, because their investment policy statements prescribe the holding of certain bonds (such as sovereign debt and high-quality corporate issues).

Other investors have bought negative yielding debt for total return, under the assumption that central banks and other investors will buy these bonds at even lower yields in the future (resulting in potential capital gains by driving the same bonds’ prices even higher).

So far, what are some of the lessons from negative policy rates and negative yields overseas?

Negative interest rates have not yet incentivized higher spending growth. In fact, households in developed markets overseas have shown a preference for holding more cash, and they have increased the amount of their savings. Likewise, many businesses are not spending to expand their productive capacity; instead, they are widely issuing bonds to finance equity share buybacks.

Negative rates have hurt bank profits by forcing banks to pay the central bank to hold reserves, even while weak economic conditions undermine demand for the banks' loans.

It is difficult for pension plans and insurance companies to match the income earned by their assets with the payouts required to meet their liabilities over time.

Could we see negative interest rates in the United States?

We believe that a negative federal funds rate has a low probability of occurring in the U.S. Negative short term rates provided little tangible benefit where implemented. In addition, it is not clear that the Federal Reserve currently has the legal authority to impose negative rates on bank reserves. This legal constraint would have to be addressed.

Market driven longer term interest rates could turn negative in a stressed economic scenario as investors search out perceived “safe haven” assets. Our expectation of positive economic growth and inflation should help against the development of negative rates.

What are some of the implications of negative rates for investors?

In the event of negative interest rates, we see three primary ways an investor could potentially lose money: loss of principal if a government debt (or other) security was held over time to maturity; the loss of purchasing power, if inflation is positive, but yields are negative; and the opportunity cost relative to other investment returns that are above zero.

Should negative rates unexpectedly become widespread domestically, investors may want to consider managing their bond holdings—and their equity holdings—a bit differently than they have in the past.

In a negative-rate world, the income potential of fixed-income holdings may become challenged. Yet, bonds can still play a role in portfolios.

Investors could consider preferred securities, which may offer somewhat higher yields, longer duration (a measure of interest-rate sensitivity), and characteristics that are more similar to equities. Investors may consider holding emerging market fixed-income investments, which can offer higher yields—but also increased volatility. Investors also can consider rebalancing fixed-income assets into equities at opportune times.

Equity dividends could become a primary source of income for some investors. Traditionally defensive sectors are likely to see greater investor demand, especially for their dividends.

Alternative investments can offer potential opportunities to benefit when traditional asset classes face headwinds. Investors may benefit from strategies that seek to capitalize upon distressed credit and falling prices among cyclical equity sectors. For qualified investors, there may be opportunities in Private Debt or Private Real Estate, which take a longer-term view of returns.

Alternative investments, such as hedge funds, private equity, private debt and private real estate funds are not suitable for all investors and are only open to “accredited” or “qualified” investors within the meaning of U.S. securities laws.

Download a PDF version of the report

1 Wells Fargo Investment Institute, “Living in a Negative Interest-Rate World,” October 31, 2019.

2 Bloomberg Barclays Negative Yielding Debt Index, March 10, 2020.