Why I'm Not Worried About Negative Interest Rates...

Nathan Slaughter's picture

Wednesday, August 14, 2019 - 12:00am

by Nathan Slaughter

The market is always driven by either fear or greed. Right now, fear holds sway. There is a global flight-to-quality underway that has investors seeking shelter in government bonds, the safest of all harbors.

As we know, bond prices move inversely to yields. So, payouts have fallen off a cliff... 3%, 2%, 1%.

Look out below.

Current bond yields are so low they would be laughable – were they not jeopardizing the retirement of hard-working people.


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My premium newsletter, High-Yield Investing, has been around for fifteen years. When the newsletter was launched in July 2004, decent payouts were plentiful. The 10-Year Treasury yield stood at 4.7%. And AAA-rated corporate bonds carried a generous average coupon of 6.7%.

That means you could draw up to $6,700 in annual income for every $100,000 invested – with minimal principal risk. Sadly, those days are long gone.

Spurred by the latest retaliatory strikes (currency manipulation) in the ongoing trade war, investors have been fleeing equities. The Dow Jones Industrial Average was already on a five-day losing streak before its 800-point collapse on August 5.

Those proceeds are pouring into government bonds, hence the precipitous decline in yields. The current yield on a 10-Year Treasury bond has slid to 1.6%. The 30-year bond yield has tumbled to just 2.1% -- only a few ticks away from the lowest level ever recorded.

ECB Germany
 
​Seat of the European Central Bank in Frankfurt, Germany

Negative Yields Everywhere
Believe it or not, those are among the best rates you'll find anywhere in the developed world. They are screaming bargains compared with other government debt. Rates on 10-year and 30-year U.K. notes have dropped to 0.43% and 1.08%, respectively – both new all-time lows.

But here's what will blow your mind... Demand for some government bonds has been so fierce that prices have risen above face value and yields have turned negative. That's right... the premium paid on the bond is more than the interest received until maturity, meaning investors are deliberately accepting below-zero payouts.

The 10-Year German Bund just touched a fresh low of minus 0.60%. You can do a little better on the 30-year and only have to pay 0.13% for Berlin to hold your money.

How could this happen? Basic supply and demand fundamentals.

Unlike Uncle Sam, Germany's fiscal house is in order and the government isn't borrowing hand-over-fist to cover spending. So, issuance (supply) of new bonds isn't nearly enough to meet insatiable demand from investors looking for a place to safeguard their cash. Hefty bond purchases from the European Central Bank (ECB) are also playing a role.  

It's not just Germany. Yields on French and Dutch debt are also negative. Ditto for Ireland and Switzerland. According to Merrill Lynch, roughly $14 trillion in global bonds are currently trading with negative yields – almost one-quarter of the world's entire bond market.

Could U.S. Rates Turn Negative?
This can be a tough concept to grasp (you probably won't find it in many finance textbooks). Our entire financial system is built around the notion that a dollar today is worth more than a dollar tomorrow because it earns interest. Negative rates turn that upside down. Yet, it's possible to buy these bonds and still generate positive returns. If this flight to quality accelerates, then bond premiums can rise even higher (driving yields even further below zero). So today's investors might be able to pocket a capital gain tomorrow.

Also, there is a difference between these nominal rates and real (inflation-adjusted) rates. Flat and inverted yield curves are signaling the possibility of deflation on the horizon. This is a real concern (just ask Japan). You could receive a minus 1.0% on your money at a time when the prices of goods and services decline by 2% and still come out ahead, just as you would from earning positive 3% at a time when inflation runs 2%. Mathematically, there is little difference. Still, no investor should have to rely on deflation.

When I first broke into this industry 20 years ago, I never envisioned a scenario where a 1.6% yield would be considered among the world's highest. But U.S. Treasury bonds are downright lofty compared with Europe. No less an authority than Pimco Chief Investment Officer Daniel Ivascyn suggested U.S. Treasury prices still have considerable room to run.

Could U.S. yields turn negative? Not likely -- but it's not as far-fetched as you might think, either. Yields on the 2-Year note settled as low as 0.14% in 2011 before the Fed lifted rates. Today, the 2-year note is yielding 1.63%.

But the Fed isn't tightening this time – it's loosening. So are other central banks. India just cut rates by a quarter-point this week, New Zealand by a half-point. This is a coordinated response to slowing industrial and manufacturing output and a pre-emptive move to stimulate growth that has been stymied by the ongoing trade war. 

Action To Take
The fact that institutional investors are intentionally locking in their money at negative yields just to keep it safe is a sure indication that this prolonged low-rate environment isn't giving way anytime soon.

Rest assured, I'll be watching all of this closely in the weeks ahead. For now, the 4% to 6% payouts on most of the holdings in High-Yield Investing are looking better and better -- especially when you consider the average S&P 500 stock yields less than 2%. We even have a few holdings that yield even higher, but of course, they come with a little more risk.

The point is, you don't have to settle for low yields like the rest of the crowd. Sure, income investors are up against it, but with our experience and track record, my subscribers and I are in good shape for whatever the market has to throw at us. And if you'd like to join us, you can learn more about High-Yield Investing right here.  

Nathan Slaughter does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.