The Unintended Consequences of Negative Interest Rates

Quarterly Letter

THIS LETTER IS MORE TECHNICAL AND COMPLEX THAN WE TYPICALLY WRITE BECAUSE THE MARKET IS PRESENTING US WITH VERY UNUSUAL CIRCUMSTANCES WHICH WE THINK NEED MORE EXPLANATION. IF YOU WOULD LIKE TO DISCUSS FURTHER, PLEASE DO NOT HESITATE TO CALL US.

As inconceivable as it might seem, worldwide, about $17 trillion of bonds have negative yields, i.e. investors must pay to own them. In Denmark, banks actually offer home buyers negative interest rate mortgages, meaning they pay you to borrow to buy a house (although they probably charge hefty fees to make the transaction profitable).

Although the negative interest rate environment (NIRE) is a fact of life currently in Europe and Japan, it has not come to North America for now, or should we say “yet”.

The only cases in history when we can observe NIRE are in Switzerland in the 70s, Switzerland again, Japan and Europe. While the Swiss NIRE episode in the 70s does not really reflect the current economic situation, the other three cases have too short a history to draw any empirical conclusion. Since NIRE never really existed before, we can only speculate on the possible outcomes and avoid areas of investment where the risk of getting hurt is the highest.

  • Our banking system depends on a positive interest rate environment. Deposits are made by savers in return for interest income from the banks. The banks thus can make loans and buy securities in order to generate income for themselves. In a normal world, the difference between what banks pay to savers and what they get from investments, the spread, is their revenues. In a NIRE, the banks would be punished (their revenues would fall) for providing credit unless they start charging interest for deposits from savers; Let us assume the banks will charge interest on deposits. Just imagine how many people would rather have their money “under their mattress” instead. If most savers come to this same conclusion, it would be tantamount to a run on the banks – the liquidity (i.e. cash) would be removed from the financial system;
    To make matters worse, the German government is considering outlawing negative deposit rates. Why would banks take any deposits if they cannot make a profit on them? Maybe they can charge service fees… they are already expert in charging fees…

 

  • Many valuation models we use today in the world of finance come from concepts that were developed in the 60s and the 70s with the assumption that the interest rate is a positive number. Nobel prizes have been awarded to economists who came up with option pricing models, efficient frontier and the Capital Asset Pricing model. Trillions of dollars of securities and derivatives are priced daily using these valuation models. The problem is some of these derivative securities would be worth an amount equal to “infinity” if interest rates were to be negative…

 

  • In a similar vein, pension funds use an interest rate (called the discount rate) to determine whether they are properly funded. If that rate is negative, most pension funds will be under funded. Moreover, if they buy bonds that have a negative interest rate, it will guarantee that that pension funds will never be able to meet their “obligations” towards pensioners, unless they change their contractual promise, as GE is doing right now for the future of their pension plan.

 

  • As rates approach zero, most fixed income investment vehicles with longer maturity dates become more and more volatile. It then defeats the purpose of diversification in the context of basic portfolio management (allocation between equity and fixed income). Unless we can be sure that fixed income investment will always move in the opposite direction of equity (of which we are not sure if we look at historical data), we will risk owning assets that have the same volatility characteristics. For that, fixed income strategies will need to be redefined properly in order to reflect investors’ real needs and risk profiles.

 

  • If NIRE became the reality in the North American market place, buying bonds with a negative rate would be equivalent to going to the casino to bet on the direction of interest rates since investors will have to pay to participate. If you buy short term bonds, you are guaranteed to lose a little. On the other hand, if you buy long term bonds, you can make good money or lose big money in the short term with interest swings.

Our fixed income strategy

Most people invest in fixed income for the wrong reason. While they say their stated objective is to receive income and have less volatility, they actually are focused on the market prices of the fixed income vehicles over the very short term (which move when interest rates move).

In general, we rarely hear clients ask us about the income their portfolio is generating. Instead, they are basically concerned with the market value of their portfolio daily (thanks to the internet and their custodians’ website). It would be analogous to an investor owning several apartment buildings (the equivalent of a diversified portfolio of stocks and bonds) asking his general manager not about the rent each building is bringing in (the equivalent of dividends and interest income each security is paying) but how much each building is worth…every day…

We design our fixed income strategy for the purpose of generating income. We choose securities with the objective of holding them until maturity. Thus, the yield to maturity is of utmost
importance to us. We also choose securities that pay higher income than average, and we diversify our risk by owning an extremely large number of different securities.

By contrast, many fixed income strategies (mostly used by mutual funds) are based on long maturity bonds that have benefited from the big decline in interest rates in recent years, we should say in the last 37 years (since 1982). As interest rates approach zero, these long maturity vehicles will become more and more volatile, with practically no income generated.

Moreover, the performance* over the income coupon is only capital gain or loss on paper unless it is sold. Held to maturity, investors only get the coupon payment, in this case, around 2% at best (as we said many times on the phone to clients: if you buy a bond with a 2% coupon and a year later, you have a performance number of 8%, what do you think it comes from if it is not 6% in paper gain?). We don’t believe we have the skillset to get in and out of the bond market to capture the capital gain potential. We believe it is easier to buy good companies’ common stocks and hold them over the long term for the capital gain purposes. We believe our strategy fits more appropriately into the objective of generating income. We believe most fixed income products are no longer appropriate for the average investor unless his/her objective is to speculate on the direction of interest rates.

 

(*) A bond that pays 1.625% interest and matures in 10 years is worth $1,000 if the long-term interest rate is at 1.625%.

If rates decline to 1% a year from now, the bond price will theoretically go up to $1,060, giving the investor a capital gain on paper of $60, i.e. 6% plus the interest income of $16.25 for a total return of 7.625%. If you sell it, you will crystallize the capital gain but you will forgo the higher rate of interest of 1.625% for the next 9 years as you will only be able to replace it with a similar bond that pays 1%.

If you keep it - you will receive the original rate of 1.625% each year and your capital of $1,000 at maturity in 10 years.

This is an example of: “you can’t have your cake and eat it too...

if rates were to go up to 2% instead, the bond price would decline to $960, creating a capital loss of $40, i.e. 4% minus the interest income of $16.25 for a total loss of 2.375%. In this case the same principal applies - if you keep the bond you will receive your 1.625% each year ($16.25) until maturity when you will receive your $1,000 in capital back and never incur a loss.

What year is it? (part 2)

Since our last quarterly letter, the market has been flat but more volatile. The many companies mentioned in the letter (Uber, Lyft, Beyond Meat, Shopify, Lightspeed, Slack, Zoom) have not been as lucky, having fallen on average 20%. As we wrote back then, some of these companies will survive but most will be worthless. Let us add one more company that tried and failed to go public: The We Company. It calls itself a “Tech Company”.

According to the filing, “We provide our members with flexible access to beautiful spaces, a culture of inclusivity and the energy of an inspired community, all connected by our extensive technology infrastructure”. This is primarily a company whose main business is to offer office space sharing. Yet, the word “technology” was mentioned 110 times in the IPO filing. Where is the technology? Providing Wi-Fi, phone and video conferencing equipment may qualify…but… It also said: “we are a community company committed to maximum global impact. Our mission is to elevate the world’s consciousness”. It sounds more like a religion than a Tech company, doesn’t it?

The We Company posted revenues of US$1.54 billion for the first half of 2019 but lost US$ 900 million. Yet, they were planning to go public with a valuation of US$ 47 billion. Worse, the company managed to convince (with a big pay cheque) a nine-member underwriting group to promote its IPO and it includes major banks like JP Morgan and Goldman Sachs. This makes us wonder a lot about the investment bankers’ ethics and the conflict of interest inherent to the business of underwriting and portfolio management under the same roof.

…the greater fool theory is alive and well…

 

Your comments are welcome.

 

The Claret Team