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Negative interest rate: How to make a virtue out of necessity

Institutional investors with limited risk capacity must include risk-free investments in their allocation, even if this involves costs. An interest rate normalization is not in sight. All the more reason for them to improve their returns through effective diversification and optimized risk management.

  • The current low interest rates correspond to a long-term trend of falling real and nominal interest rates.
  • Central banks are not to blame for the low yields, rather they have reinforced and accelerated a long term trend.
  • Even if monetary policy normalizes, interest rates - and thus yields - are likely to remain below the long-term average.
  • Does it still make sense to invest in government bonds or low-risk bonds with negative yields? The answer is “YES”. First-class bonds diversify and stabilize the portfolio. They belong in the portfolio, even if this involves paying a premium.
  • Investors should not compensate for the low/negative bond yields with additional risk or more complexity. It is better to improve the efficiency of the portfolio through optimized risk management.
  • An efficiently diversified equity portfolio allows for a higher equity exposure without exceeding the risk budget. It thus also delivers a higher expected return. 

Central bankers are not superheroes

As a high school student I was fascinated by the central banks and their power to print money. In my naive vision of the economy, they would be able to solve the world's problems with their "seigniorage power". Later, at university, disillusionment followed: I realized that my supposed superheroes could neither do magic nor print money at will without risking doing more harm than good. The greatest risk would be to lose their highest attribute, namely their credibility. I have also learned that the interest rate cannot drop below zero: Why would anyone give up consuming today and instead lend money to consume tomorrow, if tomorrow they will receive less than today?

... or are they?

Today even orthodox principles are crumbling: The central banks' money printing machines are running relentlessly, leaving a quarter of the world economy (measured by GDP) with a negative interest rate. Was my once naive view of the role of central banks correct after all? Are they superheroes after all? The economy is doing well, unemployment is relatively low, there are no inflationary pressures, the financial markets are delivering substantial positive returns and the credibility of the central banks is not being put into question (yet). Do we really have to throw out the classics among economic textbooks? There is a lively debate in the media right now between those who are concerned about the nonchalant attitude of central banks and those who see the banknote press as the solution to the world's economic problems. Among the latter are the advocates of Modern Monetary Theory[1]. Regardless of who is right and who is wrong: If the central banks stop the printing press and bring the real interest rate back to at least zero, most investors, especially institutional investors, will have more sleepless nights.

Investment emergency postponed

Supported by the ultra-expansive monetary policy, the financial markets have continued to rise unabated over the last ten years. In 2019, most stock markets recorded historically high returns. At the same time, the term pénurie de placements or Anlagenotstand, in English “investment plight” has been circulating in the Swiss media for about five years and the term is ubiquitous at every institutional investor conference. Given the juicy returns of the last five years, one may ask: What pénurie de placements?

Have the investors who have had to deal with the anomaly of a negative risk-free interest rate for almost five years learned how to deal with it, despite the fact that no textbook provides for such a possibility? Negative interest rates affect Switzerland as well as the Eurozone and - for some time now - Japan. The USA is still recording slightly positive interest rates.

The good portfolio results were possible because of capitalized future returns, i.e. they are already included in today's prices. However, this means that the returns expected in the future will be correspondingly lower. Indeed forward looking, investors are facing higher challenges than in the past years.

Replacing unrewarding investments?

For a long time it was important to avoid "Japanization" - an economy with negative or near-zero inflation, permanently low interest rates and low growth. Well-known analysts considered this scenario impossible for the European or North American economy. Today, 15 years later and with negative interest rates, we are in an even more difficult situation than the Japanese asset managers were back then.

The question is: Is it wise to invest in assets with a zero or even negative return? Shouldn't such unrewarding bonds simply be removed from the asset allocation? There is a strong temptation to replace them with substitutes that have a positive return and a recurring income. Typical candidates for substitution are real estate and corporate or high-yield bonds from debtors with poor credit ratings. In addition, alternative investments such as infrastructure investments, private loans or private equity are also considered substitutes. What most of them have in common is that their value is based on expertise and appraisal value - and not on a daily market price. The danger of forgetting the risks - implicit or explicit - is huge.

Learning from Japan

We advise investors not to switch negative risk-free returns for greater complexity and risk, as we explained in last year's research note[2]. Rather, we recommend sticking to the risk budget until the possibilities for risk optimization have been exhausted. Japanese portfolio managers stoically continue to buy Japanese government bonds, even if they have a negative return. So what is the motivation for investing in these assets? The answer is very simple: consistent management of portfolio risk and/or decorrelation.

Decorrelation and risk dilution

A key feature of investments in risk-free government bonds for a multi-asset portfolio is risk mitigation. Apart from the decorrelation effect, which is also common in other asset classes, the so-called risk dilution effect also contributes to risk reduction, and in a significant way. It arises when we combine high-risk investments with bonds that have little or no risk (measured by standard deviation).[1] First-class (risk-free) government bonds have the lowest volatility and thus the highest risk dilution effect. They are the only investments that guarantee (nominal) capital repayment at maturity. At the same time, the low or even negative correlation to equities, as we have experienced over the last 20 years, offers a further contribution to risk reduction via the decorrelation effect. Especially in times of crisis, risk-free government bonds continue to be a safe haven. They are therefore important for stabilizing the portfolio. Figure 1 shows that the correlation between government bonds and equities has remained relatively low over time and their volatility ratio (a measure of risk dilution) stable.

Other asset classes, such as commodities, may also provide a decorrelation effect. Here, however, the risk dilution effect is almost zero, as commodities have a similar, if not higher, volatility than equities[4].

Interest rate sensitivity influences diversification effect

The decorrelation effect is based on the uncorrelated yield movement of bonds relative to other assets. The price changes of bonds are determined by interest rate sensitivity, which depends primarily on the maturity and is measured by their duration. The higher the interest rate sensitivity (duration), the higher the diversification effect. Whereby a longer duration also implies a higher price variability and a slightly higher standard deviation compared to bonds with a short duration.

Figure 2 illustrates the decorrelation effect and risk dilution for a simple portfolio of bonds and equities, assuming a volatility of 25% for equities and 5% for bonds (duration of 5). With correlation 1 we only have a risk dilution effect. With a lower correlation, the decorrelation effect increases until a hedging effect (correlation -1) is reached.

The attractiveness of high-quality corporate or government bonds in a multi-asset portfolio manifests itself most clearly in times of crisis. Then, the guaranteed repayment of the (nominal) capital becomes more important than the return. Under such circumstances, first-class bonds show an even lower correlation (direction -1) than the one they have on average and offer partial protection against losses, especially in the case of bonds with a long maturity. This is an important contribution to portfolio stabilization, as can be seen in the table (Figure 3): Over the last 30 years, the global government bond index hedged in CHF performed best when the equity markets (MSCI World Index in CHF) experienced the biggest drawdown.

Risk reduction has a price - and a value

So far so good. We have just refreshed the rationale for investing in government bonds which, as risk-free investments, guarantee repayment of the nominal value at maturity. In almost a quarter of all markets, such an investment costs money. For CHF investors in particular, risk reduction through bonds in the portfolio has the highest  price compared to other reference currency. All the more reason for them to focus on optimal portfolio diversification. This is actually nothing new, but is based on modern portfolio theory (Harry Markowitz). Instead of replicating a capital-weighted equity index (indexing), we recommend optimizing the equity portfolio. Our risk-based portfolio optimization reduces the risk by 20-30% and thereby allows for a higher proportion of equities at the same risk level (see Figure 4). The improved diversification and higher efficiency ultimately lead to a higher expected return.

In summary, efficient strategies such as OLZ Optimization improve returns without compromising complexity, cost, liquidity risk or governance. In the current market situation, effective risk management is therefore more important than ever.

Outlook: Declining expected returns and efficiency frontier

The global decline in interest rates and credit spreads over the past decade has had a significant impact on expected returns and the efficiency frontier. Even in the US, where risk-free government bonds still have a slightly positive return, the efficient frontier has shifted downward and flattened. Figure 5 compares the long-term historical efficient frontier (30 years) for USD-based investments with the one over the last 10 years, which is higher. Of particular concern is the ex-ante efficient frontier for the next 10 years, which is significantly lower than the historical one and extremely flat.

This means that the effect of the pénurie de placements (investment plight)  has not materialized yet, because it has been postponed into the future. In Figure 6 we have calculated the efficient frontier for CHF-based investments[5] and compared the last 10 years to expectations for the next decade. Again, expectations are below the status quo. Overall, falling expected returns lead to a lower and relatively flat efficient frontier.

Conclusion: Bonds for stabilization and efficient equity portfolios for higher returns

Since most investors have a limited risk budget, they must include risk-free investments in their allocation, even if this involves costs. Investing in bonds acts like an insurance policy, where you pay an annual premium to reduce risks. If diversification and risk reduction is desirable and investors are willing to pay for it, then they should give due attention to risk management throughout the investment process. Efficient risk-optimised equity portfolios will play an important role over the next decade, and in the long term they will help to generate higher returns. 

Low and even negative returns make risk management a central task of any investment strategy. The goal should always be to build an efficient portfolio given a specific risk budget.

Central banks - the real "bad guys"?

Negative nominal interest rates and ballooned balance sheets are lasting, and the central banks have communicated this more or less explicitly. The extent to which the financial markets are dependent on the central banks medicine was experienced in November and December 2018. The panic-like market correction immediately led to a return to the proven expansive monetary policy that has characterized the last 10 years.

It is not bold to say that interest rates will normalize anytime soon. Nevertheless, the question that arises is what a normal interest rate level is.

What is a normal interest rate level?

What can be considered a normal interest rate? A very informative and well documented study was recently presented by Prof. Schmelzing of Harvard University.[1] Using a fabulous collection of data spanning 700 years, he shows that real and nominal interest rates do not fluctuate around a constant "normal" level, but rather fall continuously. The last 30 years, which have been characterized by falling nominal and real interest rates, are therefore not an abnormality but a convergence towards the historical trend of falling average interest rates.

One conclusion is that negative real interest rates are not unusual. Over the 700 years that have been analyzed, the share of countries/economies (measured against GDP) with negative real interest rates has increased from an average of 15% to about 30%.[2] For the coming decades, Prof. Schmelzing dares to predict that real yields could become negative. Apart from the strong implication of this statement, the study shows that historical average nominal and real yields are not a good reference. Rather, we have to assume that average values will decline.

Furthermore, the study comes to the conclusion that central banks have at best accelerated, but certainly not triggered, a long term interest rate dynamic in developed economies. We would have had to deal with falling or near-zero real interest rates anyway - even without an expansive monetary policy. From this perspective, "central bank bashing" seems exaggerated.

[1] Paul Schmelzing, “Eight centuries of global real interest rates, R-G, and the ‘suprasecular’ decline, 1311-2018”, SSRN, November 2019.

[2] The study covers advanced Western economies/countries in historical comparison. The author adds up the GDP of countries with negative real returns and then calculates the percentage in relation to the total GDP of his sample.

Wie wird sich das How will the "normal" interest rate level develop?

Central banks can do a lot, but they are by no means the "masters of the universe" as the last decade has suggested. The unusual monetary policy of the last 10 years has reinforced a fundamental historical dynamic of the market towards lower nominal and real interest rates. The new normal interest rate level (where an economy is in balance between growth, inflation and employment) is below the historical average. Therefore, a normalization of monetary policy would only lead to a moderate increase in interest rates. Contrary to what many have feared, this would mean a lower potential loss for interest-sensitive assets.

[1] A brief overview of the basic principles and ideological roots of MMT can be found here: https://www.bloomberg.com/news/features/2019-03-21/modern-monetary-theory-beginner-s-guide 

Prof. Dirk Niepelt from the University of Berne recently wrote an article in the NZZ about the claim and the limits of such a theory https://www.nzz.ch/meinung/monetaere-theorie-als-perpetuum-mobile-ld.1471659

[2] OLZ Research Note- January 2019: Efficiency instead of Complexity

[3] Leibowitz, M. and A. Bova; The duration decision in diversified portfolios; Morgan Stanley Research, 2012. See also: Norges Bank Investment Management: “Risk and return of different asset allocation”, discussion note; 2016/11

[4] It is interesting to note that commodities do not yield dividends and interest or other income and in addition bear a negative return in the form of storage costs.

[5] We have considered the following asset classes: Cash (5%-30%), Bonds CHF (10%-50%), High Yields (0%-15%), Real Estate (20%-35%), Swiss Equities (10%-30%), World Equities (5%-30%), Emerging Markets Equities (3%-20%), with a max. 80% equity investment. The expected returns are derived from: Invesco Investment Solutions, "2020 Invesco Long Term Capital Market Assumptions - Swiss Francs (CHF)", October 2019. The expected variance-covariance matrix is equated with the historical one.

OLZ CIO Carmine Orlacchio

Carmine Orlacchio

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