Taper Tantrum: What Negative Rates Mean To Portfolios

Bill Gross, Wall Street’s undisputed bond guru and director of fixed income at Janus Capital, is on a Tweet-storm these days on the topic of negative interest rates already on the table in Europe and Japan.

Gross: Global yields lowest in 500 years of recorded history. $10 trillion of neg. rate bonds. This is a supernova that will explode one day

— Janus Henderson Investors (@JHIAdvisors) June 9, 2016

He’s not talking about chump change, either. According to Fitch Ratings, total worldwide sovereign debt yielding negative rates is already crested the $10 trillion mark.

Fear Spurs Upside Down Rates

For U.S.-based financial advisors, the fear is justified of negative rates coming to the states. Driven by below-zero bond rates abroad, especially in Germany, the benchmark 10-year Treasury note is offering its lowest rate in over a year, at 1.46 percent, in late June.

Comparable rates on 10-year Japanese notes stand at -0.155 percent, and the 10-year German note is only slightly above sea level, at 0.011 percent.

“Low to negative interest rates have exacerbated the challenges facing bond investors,” Janus Capital states in a June research note.

“Demographically, the timing could not be worse," he added. "Populations’ retirement savings in much of the developed world are seeing yields on their investments shrivel and are being put increasingly at risk of a capital loss. Pensions and endowments, along with segments of the financial services industry such as insurance providers, see their business models compromised as yields in their investable universe fall well short of those required to meet future obligations.”

Financial advisors looking for a path away from negative rates for client retirement portfolios need to get creative, Gross says.

"The secret in a negative interest rate world that poses extraordinary duration risk for AAA sovereign bonds is to keep bond maturities short and borrow at those attractive yields in a mildly levered form, that provides a yield and expected return of 5%-to-6%,” he noted.

Investors should mirror the above moves with investments that are “less volatile” and that are largely unaffected by global currency and monetary policy trends.

"This can be done," Gross said. "Closed-end funds at deep discounts, highly certain acquisition arbitrage stocks, as well as volatility sales, are general examples."

Fear the Fear: Negative Rates Raising ‘Red Flags’

Investors are leery about the negative direction of interest rates, with some saying it’s a huge red flag for the financial industry in particular, and for the economy, in general.

“There are so many financial institutions out there buying future contracts, you have to wonder if negative interest rates would cause many financial institutions to collapse,” said J. Saleem, owner of Suprex Private Tutoring, start-up training company (Saleem regularly puts some of his company’s capital into an investment fund.) “I believe this will cause a massive selloff in the economy and maybe even a collapse.”

Implications for U.S. monetary policy are huge, too, as all eyes turn to the Federal Reserve to see what moves it will make, if any, with U.S. interest rates. “The most basic implication, to me, is how can the Federal Reserve raise rates when money travels electronically across borders?” asked Peter Miller, author of the 2017 Edition of “The Common Sense Mortgage.”

“For instance, since the Fed raised its target rate in December mortgage rates have fallen nearly half a percent," he said. "There's a reason nonbanks are capturing more and more market share, and lower rates are one of them.”

Other financial experts say that risk, as an investment issue, is bigger than ever and that, more than anything else, is driving rates downward.

“Negative interest rates are a timely topic with the unexpected departure of Great Britain from the European Union,” said Cesar Canizales, an economics professor at Richland College, in Dallas, Texas. “But the simple and obvious answer is risk. Investors are going to have to take on more risk because the banks and companies are flush with money. There is not enough global demand to put this money to work.”

The immediate beneficiaries are currency investors betting against the euro, and they are having a good day, said Canizales.

“It also may mean that, in this new negative interest rate environment, we will have to pay a fee to use the banking system,” he added. “We've taken for granted that banks would always pay us for the use of our money, but in this new era of low or no interest, the banks and corporations simply cannot put their money to work, and consumers are either tapped out or not willing to take on more debt. This bank fee may be a needed income generator.”

A negative interest rate could reduce the cost of borrowing, but may also incentivize the underground market, Canizales explained.

“Additionally, hard, tangible assets become more appealing in an era of negative rates,” he said. “That includes real estate, machinery and buildings as investments that can generate cash flow.”

Tough Conversations Ahead?

Financial advisors will have to tread cautiously as negative rates appear more and more on the global financial markets horizon.

Aside from the downward effect negative interest rates are having on the world’s fixed income market, money managers will have to refocus on risk, and decide how much of that risk is necessary enough to accept upside down interest rates.

Worse, they’ll have to explain to clients why negative rates may someday have a place in their retirement portfolios.

Brian O'Connell is a former Wall Street bond trader and author of the best-selling books, such as The 401k Millionaire. He's a regular contributor to major media business platforms. He resides in Doylestown, Pa. Brian may be reached at [email protected].

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