Interest Rates – Falling Below Zero

October 26, 2016

In January 2016, the Bank of Japan (BOJ) followed the lead of the European Central Bank (ECB) and, for the first time in its history, adopted a negative interest rate policy (NIRP).¹ With this unorthodox move, Japan, like its predecessors, was attempting to kick start a stalled economy. Lackluster economic growth and accommodative central bank policies have resulted in depressed and, in some countries, negative sovereign yields. The dearth of yield has prompted overseas investors to rush into the U.S. investment-grade bond market, which continues to offer high-quality, positive-yielding securities. As a result, U.S. Treasury rates have declined and credit spreads have tightened, increasing the possibility that negative rates may become more prevalent in the U.S.   At IR+M, we view these dynamics as an opportunity to leverage our strength in security selection and uncover lesser known yield prospects.

Negative Yielding Sovereign Debt

Since July 2009, six central banks have adopted NIRP in an effort to stimulate economic growth, increase bank lending, and spur inflation.¹ While the economic impact of the move has been debatable, NIRP has driven the amount of outstanding negative-yielding sovereign debt higher. As of September 2016, the universe of sub-zero government debt totaled $10.9 trillion – a roughly 65% increase year-to-date.¹,² Japan comprised the largest share of this outstanding debt at $6.9 trillion (63% of the total), followed by France at $1.1 trillion (10%), and Germany at $1 trillion (9%).² Leading up to and following the Brexit vote in June, investors have flocked to high-quality government debt, which has driven down yields and meaningfully increased the size of the sub-zero debt universe.

The Impact of Foreign Buyers on Treasury Yields

The free-fall in global government bond yields has caused investors to search elsewhere for income. Although the cross-currency basis swap* has become increasingly expensive for foreign buyers, the U.S. Treasury and credit bond markets are two remaining sectors to offer any yield. This yield differential between the U.S. and certain developed nations’ debt has become increasingly pronounced due to the Federal Reserve’s (the Fed) October 2014 decision to end quantitative easing. Conversely, the ECB and BOJ have continued with their asset purchases, which have reduced their respective government bond yields to nearly zero – or in some instances, negative. With few alternatives available, overseas investors have been in search of safe havens that provide a yield advantage, and in many cases, those havens have been the U.S. Treasury, corporate, and securitized bond markets. The ongoing influx of billions of dollars from foreign investors has pressured Treasury yields to historical lows, and provided U.S. companies with seemingly endless demand for their debt.


Negative Rates Have Arrivedtb2

While the Fed has thus far resisted adopting NIRP, the reality is that sub-zero rates are in the U.S., and have been since 2010. In October 2010, the Treasury issued $10 billion of 5-year Treasury Inflation Protected Securities (TIPS) at a -0.55% real yield, which was the first time negative yields were issued at a U.S. debt auction. Away from a few breaks into positive territory, TIPS real yields have remained mostly negative since 2010.¹ While the Treasury auction rules permit the issuance of TIPS at negative real rates, the same does not apply to nominal Treasury debt, such as bills and bonds. Although nominal Treasuries are not sold with negative yields in the primary market (the minimum is zero), they can trade – and have traded – at negative yields in the secondary market. While the initial optics of negative yielding TIPS and nominal Treasuries appeared disconcerting, the mechanics of both markets have remained largely unaffected by sub-zero rates, which have become more conventional.

Why Invest in Negative Yielding Bonds?

When the German 10-year bund sold at -0.05% in July 2016, it was a watershed moment for many investors.³ Germany became the first Eurozone country to sell 10-year debt at a negative yield; as a benchmark issue in Europe, it established a precedent for other nations to follow.³ Germany’s sub-zero debt auction also further fueled the debate over why investors purchase negative yielding bonds. We believe that, for many investors, the primary motivation for doing so is the perceived safety of high-grade bonds and potential for price appreciation. For some investors, the need for capital preservation exceeds the risk of negative returns. For others, the possibility that rates become increasingly negative, and result in higher bond prices, is a risk worth taking. Additionally, in some countries, deposit rates are even more negative than sovereign bond yields, making that debt relatively more attractive. Further, regulatory requirements may cause certain investors to purchase specific assets regardless of their yield.

Positioning at IR+MPicture2

With negative yielding debt pervasive globally, many investors are in search of incremental yield in the U.S. The resulting impact has been persistently low volatility and tight credit spreads. In this environment, actively managed strategies that employ ongoing security selection and sector rotation may deliver excess return. At IR+M, our strategies are well-diversified and traditionally include allocations to high quality corporate bonds, ABS, Small Business Administration (SBA) loans, Agency and Non-Agency CMBS, and Agency fixed- and adjustable-rate mortgages. Our investment philosophy is consistent across the complex, and centers on our disciplined, bottom-up approach to uncovering issuers that have strong fundamentals and low idiosyncratic risk. Accordingly, these strategies have the potential to perform well in a multitude of interest rate scenarios.

At IR+M, we maintain a steadfast commitment to bottom-up security selection and sector rotation, which we believe can drive excess returns in the most challenging interest rate environments. With yields on bellwether bonds at historical lows, we believe that our well-diversified, duration-neutral strategies are viable options for investors who are in search of additional yield.

¹Bloomberg Barclays. ²Fitch.  ³Wall Street Journal. ⁴Representative portfolio characteristics as of 9/30/16. Some statistics require assumptions for calculations which can be disclosed upon request. A similar analysis can be provided for any portfolio we manage. ⁵Yields are represented as of the above date and are subject to change.

*Cross-currency basis swap: The cost to borrow one currency in exchange for another.

The views contained in this report are those of IR+M and are based on information obtained by IR+M from sources that are believed to be reliable. This report is for informational purposes only and is not intended to provide specific advice, recommendations for, or projected returns of any particular IR+M product. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Income Research & Management.