Negative interest rates are becoming all the rage. It follows on from the post-GFC fad of quantitative easing and many countries now have them; and even some companies too.
Quantitative easing was popular for some years but was generally found to be unsuccessful at stimulating demand and economic growth. So now negative interest rates are being used with the result that borrowers are paid to borrow by lenders.
Negative interest rates have become so eagerly sought after that it is not just short term debt that comes with a negative yield, but long term debt as well.
Austrian and Swedish government bonds have negative yields out to five years. German and Danish government bonds have negative yields out to six years.
But it is the Swiss that are way out in front, with negative government bond yields out to 13 years.
Companies are getting in on the act with bonds issued by highly rated European companies Nestle, EDF and Shell trading in the secondary market at negative yields.
Bonds issued by Deutsche Bahn, Sanofi and Novartis are trading with yields around zero to negative.
Needless to say this creates all sorts of problems, regardless of the dictates of fashion or even whether negative interest rates will be any more successful at generating economic growth than quantitative easing. Indeed, it may even do the opposite and lead to economic collapse.
Why would investors buy bonds with negative yields? Because interest rates could become even more negative, and then the bonds would be worth more.
However, this requires someone to be prepared to lose even more money than you are. Hmmm.
Saving for retirement via a pension fund would seem pointless. Savers would be better-off stuffing the money under the mattress.
Insurance will become very expensive as insurance companies have to pay to invest premiums collected. This means premiums will have to go up, which will result in insurers having to pay more to invest the premiums, which means… you get the picture.
Insurance companies could go broke.
And what about government revenue collection i.e. taxes? Do negative interest rates paid on investments become tax deductible? Presumably the coupons earned by borrowers will be taxable.
Depending on whether a country is a net borrower or saver, government revenues could rise or fall, accordingly.
For countries that are net savers, negative interest rates could be bad news and could be viewed as a ploy by the central bank to expose the limitations of monetary policy and force governments into using fiscal policy to stimulate economic growth. For countries that are net borrowers, increasing government revenue collections may allow the government to pay-off its debts but then why would it want to? Logically it should encourage everyone to borrow more and get paid to do so.
This is doing my head in and maybe I am getting confused. But let's explore this a bit more.
How are negative interest rates paid? Somehow collecting regular payments from investors does not seem like a recipe for success - no matter how fashionable negative interest rates may be.
If we think of a bond with a fixed rate of return - make that a payment - then the concept is relatively simple. The bond would be sold as a zero coupon bond but rather than being sold at a discount and being repaid at face value, it will be sold at a premium and repaid at face value.
Simple!
But if you want to sell a floating rate note with the coupons or rather payments reset periodically, the mechanicals seem to fall apart. This was highlighted in a report from Moody's Investor Service.
Moody's identified 13 Australian originated RMBS and ABS transactions that have issued Euro denominated notes. Those notes carry coupons that are calculated with reference to a Euribor base rate plus a credit margin.
Three month Euribor is currently -0.2% per annum and six month Euribor is -0.125%.
While the credit margin applied to Euribor results in an overall yield that is still positive, there is no problem. But should the result be negative, problems arise.
If the overall yield is negative, the issuer of the notes will have to pay the swap counterparty to the transaction the negative yield, rather than the other way around. In theory this should be fine, because the issuer should collect negative coupons from investors - but this won't happen, will it?
The investors may well refuse to pay and settle for receiving no coupon payments at all. This will leave the issuer out of pocket, as it will still have to pay BBSW plus a margin to the swap counterparty and then pay the counterparty Euribor plus a margin.
Under normal circumstances the issuer could seek to buy back the notes it has issued. They should be worth less now that coupon payments have ceased. But in the upside down world of negative interest rates the notes will actually be worth more.
Perhaps the issuers of the RMBS and ABS will have no option but to declare insolvency and seek to have the transactions wound up.
Will this make the notes worth less or more?
- Philip Bayley is editor of the weekly capital markets bulletin, The DCM Review.