Most of the time, my memos have their origin in something interesting that’s happening in the world or in a series of events I come across that I think can be interestingly juxtaposed. This one arises from a less usual source: a request.

The other day, my colleague Ian Schapiro, the leader of Oaktree’s Power Opportunities and Infrastructure groups, suggested I write a memo about negative interest rates. My reaction was immediate and unequivocal: “I can’t. I don’t know anything about them.” And then I realized that’s the point. No one does. But Ian thinks I can make a contribution, so I’ll try. I’ve been saving up clippings on this subject, as you’ll see. Ian’s urging set me to work.

For a good while now, I’ve used the term “mysterious” in connection with inflation (and deflation). What causes rapid inflation? How can it be stopped? Economists offer explanations and prescriptions regarding each occurrence, but they rarely apply the next time.

And that brings us to the subject of negative interest rates. I find them no less mysterious. The fact that we know what they are – as we do with inflation and deflation – doesn’t alter the fact that we don’t know for sure why negative rates are prevalent today, how long they’ll continue in force, what might cause them to turn positive, what their consequences are, or whether they’ll reach the U.S.

No, I’ll Pay You!

Historically – until the European Central Bank took the rate on its credit facility to -0.10% in 2014 – borrowers paid interest to the people from whom they borrowed money. But in the recovery from the Global Financial Crisis, interest rates went negative for the first time in recent history, meaning some lenders paid borrowers for the privilege of lending them money.

I had my first direct brush with negative interest rates in 2014, when I was making an investment in Spain. The closing was due to take place on Monday, and I wired funds on the prior Wednesday so as to be in position to close. The following conversation ensued with my Spanish lawyer:

Carlos: The money has arrived. What should I do with it between now and Monday?

HM: Put it in the bank.

Carlos: You know that means you’ll get less out on Monday than you put in today.

HM: Okay, then don’t put it in the bank.

Carlos: You have to put it in the bank.

HM: So put it in the bank.

That’s it in a nutshell. Money can’t be free-floating in space. It has to be someplace. And you can’t keep much of it in your wallet or under the mattress. Thus, in general, any substantial sum has to go into the bank. And in Europe – then and now – doing so means you’ll get out less than you put in.

I have to admit that this didn’t come as a shock to me. Oaktree and I had turned very cautious in 2005-06, and as a result, all of my money that wasn’t in Oaktree funds was in a “laddered portfolio” of U.S. Treasurys. (In my case, equal amounts of 1, 2, 3, 4, 5 and 6-year maturities. When the closest-in note matures, you roll it to the end of the line. It’s the most mindless form of investing known to man.)

At the time I put that portfolio together, I signed up for a yield in the range of 5-6%. And I was thrilled: the greatest safety, total liquidity and a meaningful yield. But then, in 2007, the Fed started cutting rates to rescue the economy from the sub-prime mortgage crisis. And one day in late 2008, my banker called to say, “The 6% note has matured. You can roll it over at five-eighths.” I asked, “What-and-five-eighths?” “No, that’s it,” he said, “just five-eighths.”

The world had changed. Up until the Global Financial Crisis, we could store money with the government and be well paid to do so. But now my reaction was, “given the level of fear in the financial world, maybe one of these days people will end up paying to store their money safely.”

In the period 2008-14, Europe experienced the Global Financial Crisis, a European debt crisis (with concern over the solvency of “peripheral” nations on Europe’s southern tier), and rapidly escalating prices for commodity raw materials. In response, the European Central Bank and some non-EU countries moved to adopt negative interest rates. Here’s how it goes:

Commercial banks usually earn interest on the extra reserves they keep with central banks, like the Fed or the European Central Bank. Negative policy interest rates force them to pay to keep money in those accounts, a penalty aimed at pushing them to lend more and goose the economy. (The New York Times, September 9)

Central banks determine short-term base rates (“policy rates”) as described above. That establishes the origin of the yield curve, and rates/yields on other types of short-term debt, as well as longer-term instruments, can be expected to respond by moving to a logical relationship with the base rate. Eventually, negative interest rates paid on bank deposits should be reflected in negative yields on bonds. (Note: for the most part, negative rates are applied today only to large deposits. Small depositors have thus far been spared.)

Today, large numbers of bonds – the vast majority being government bonds from Europe and Japan – carry negative yields to maturity. They constitute roughly two-thirds of the bonds in Europe and 25-30% of all the investment grade debt in the world. A few corporate bonds also offer negative yields, however, and there’s even a handful of negative-rate high yield bonds (the ultimate oxymoron).

Further, on September 4 Bloomberg pointed out the prevalence of negative real rates:

While over $17 trillion of the global stock of debt trades at nominal yields below zero, the figure jumps to $35.7 trillion when inflation is taken into account. . . . In the U.S., more than $9 trillion of the nation’s government debt carries yields lower than the CPI rate.

With a negative-rate instrument, the price you pay for a bond today exceeds the sum of the face amount that will be repaid when it matures plus the interest you’ll receive in the interim. That means if you buy a negative-yield bond and hold it to maturity, you’re guaranteed to lose money. Why, then, would anyone want to buy a negative-yield bond? Here are some reasons that make sense:

  • Fear regarding the future (relating to recession, market declines, credit crisis or further declines in interest rates, among other factors) that causes investors to engage in a flight to safety, in which they elect to lock in a sure but limited loss.
  • A belief that interest rates will go even more negative, giving holders a profit, as it implies bonds will appreciate in price (as they would with any decline in rates).
  • An expectation of deflation, causing the purchasing power of the repaid principal to rise.
  • Speculation that the currency underlying the bond will appreciate by more than the negative interest rate.