For a variety of reasons, widespread negative interest rates probably won’t happen in America, at least in the near future. Below zero interest rates are hugely stimulative and wouldn’t be appropriate when government figures indicate growth over the last 12 months is somewhere above zero, depending on who is massaging the numbers. It’s reported that we’re the fastest growing economy amongst the developed nations. Rather than lowering rates further, our economy is seen as robust enough that the Fed has hinted at actually increasing rates this year or early in 2016.
Not every economy is doing as well as the United States. Many nations have negative growth. For example, there is a deflationary undercurrent threatening most of the European Union and many rates have turned negative. The economist John Mauldin writes, “We read that some 25% of bonds in Europe now offer negative interest rates. How do your value equations work in an environment of negative yields? It becomes mathematically impossible for pensions and insurance companies to meet their goals, given their investment mandates, in a world of negative interest rates.”
Even though we’re probably not going to be faced with interest rates below zero, this period of below-normal rates might continue for a while. If we think a little about it, there are two material consequences to an extended period of below-average rates. The first is that long term bond investors will not easily meet their legal obligations, as John Mauldin says. The benefits of compounding interest at the previously expected higher rate just won’t have occurred. The other consequence is that the first may not matter: insurance companies and pension funds might not survive in their present form.
Hypothetical A: Low Rates
Some of the complications of a negative interest rate environment are that heavy bond investors like pension funds and insurance companies may not be able to honor current obligations. Between 1990 and 2001 the average interest rate on a 30 year Treasury bond (the “long bond”) was 6.70%. Annuity contracts were written based on compound yields at least that high. Many expectations were 8% or more. Rates dropped after the Great Recession and the average long bond rate between 2007 and 2014 was 3.75%. Right now it’s even less.
There are restrictions on what investments, pension funds and insurance companies can buy with their reserves. Investment grade bonds are one of the authorized possibilities. And the recognized highest quality bond is a U.S. Treasury issue. This is important because pension funds and insurance companies strive to offset their contractual obligations with maturing bonds, oftentimes with Treasuries. Regular people do that as well, like when they buy a bond every year so when little Tiffany becomes 18, her college expenses will be funded.
Pension funds are the counterparty to a legal obligation. One party is the employee (or employer, or both), who agrees to deposit money at intervals for an extended period. The other party is the pension fund who agrees to manage the deposits and return a certain amount every month after the employee retires. Typically, the total expected return to the retiree (assuming normal life expectancy) exceeds the employee’s cumulative deposits. This is possible only if the interest earned on the savings (appropriately compounded) meets the pension fund’s forecast.
The problem is that when the fund bought those long bonds 25 or 30 years ago interest rates were a lot higher. In 1990 the 30 year T-bond paid 8.26%. When the bonds mature and are replaced with the contemporary equivalent bond at a 3.76%, the yield no longer is sufficient to honor the fund’s obligations. The fund may seek legal relief (“Your honor, don’t pay any attention to those screaming retired people outside. The evidence proves we can only pay 40 cents on the pension dollar. Please revise our annuity agreements accordingly. We’ll leave by the back door.”) Or it may have to sell from its reserves to fund retirement checks. There’s a limit to any fund’s reserves, and if this alternative were chosen the fund will eventually collapse.
Best estimates put U.S. bond market at around $37 trillion versus a domestic stock market at about $22 trillion. Using those figures, the bond market is 68% larger than the equity market. It wasn’t always that way. The inflow to bond funds significantly increased after the dot.com crash of 2000 and again after the housing crash of 2008. What else could explain the growth of the Vanguard Total Bond Market Index Fund (VGTLX) and Pimco Total Return (PTTRX) during that period? It may have seemed a good move, but those folks may have just moved their assets out of the frying pan.
It’s not just pension funds. Insurance companies may place much of their reserves into long term Treasuries, but the same problem manifests. If reserves don’t provide for enough growth to fund its obligations the company will have to sell some of its reserves to pay claims.
The bullet point is this: if rates stay low both pension funds and insurance companies might have to sell assets to fund present liabilities because the interest on the reserves won’t be enough to meet their obligations.
Hypothetical B: Rising Rates
A little earlier in this column, we gave a kind of kiss on the cheek to the possibility of institutions having to discount their long bonds in order to sell them. We also waved hello to the possibility of rising interest rates. Here is where those two items come together.
Back in the day, Jared Dillian was an index arbitrage and ETF trader at Lehman Brothers. He authored Businessweeks top general business book of 2011, and currently writes a market newsletter for investors. He’s developing an expanding reputation for discussing complex matters (former arbitrager) simply (top general business book). Here is what Mr. Dillian recently wrote about long bonds and rising interest rates.
The key to understanding Mr. Dillian’s point is the concept of “duration”. Duration measures the price sensitivity of a bond to changes in interest rates. The shorter the maturity of the bond, the less the duration simply because the bond will be paid off sooner. A long term bond (the one that institutions buy to match long term obligations) is more subject to big value changes due to interest rate movements. Mr. Dillian uses that concept below:
“One last thing to scare the pants off you, then I’m going to go. There is a concept known as duration that people use to measure interest rate sensitivity. The duration of the on-the-run 30-year bond is about 20 years. So here’s the thumb rule: For every 1% change in interest rates, the price of the bond will decline by (approximately) its duration, in percent. So if you own a mutual fund full of 30 year bonds, if interest rates go up one percent, your investment will lose 20% in value. If rates go up two percent, I mean… I’d bet that two-thirds of bond mutual fund shareholders don’t even know the relationship between bond prices and interest rates. Boy, this is going to be fun.”
We talked earlier about “between 1990 and 2001 the average interest rate on a 30 year Treasury bond (the ‘long bond’) was 6.70%. Rates dropped after the Great Recession and the average long bond rate between 2007 and 2014 was 3.75%. Right now it’s even less.” Current interest rates are about 3% below the average rates preceding the dot.com crash. If what Mr. Dillian writes actually happens and rates only return to pre-crisis levels the long bond would lose 60% in value.
Pension funds and insurance companies (and little Tiffany’s parents) would be caught between Scylla and Charybdis. On one hand, they will not reach their distribution obligations under the yields predominating over the last decade or so. That’s the rock. On the other hand, if they had to sell their low-interest long bonds after rates return to pre-crisis levels they would only get about 40 cents on the dollar (A $1,000 bond reduced 60% leaves only 40% on the table). That’s the hard place. They would have to sell $2,500 of long bonds to net $1,000. The 30 year Treasuries would only cover 40% of the liabilities they were expected to “guarantee”. Oh, my!
Why This May Be Important
I try to be a realist. I once saw Dionne Warwick’s closet. She’s Whitney Houston’s Auntie. (Your wife will expect you to know that). Now, like I said, I try to be a realist. I know I’ll never have a closet like hers. But it doesn’t stop me from having a contingency plan in case the closet-fairy drops by for tea.
The reality of what we’ve been discussing is that there is only a small chance something like that may happen. If it does, a lot of people will be hurt. But a few may benefit hugely and it would be nice to be one of them, in which case a closet like Dionne Warwick’s becomes a possibility.
This is one way to play the sudden-rate-rise game. The concept of total return on bonds includes (a) interest received and (b) gains on sale. You know those 30 year Treasury bonds selling for 40 cents on the dollar? A 3.75% bond discounted 60% yields (at the new valuation) over 9%.
Example: Assume $1,000 bond pays $37.50 (3.75%) in annual interest. That bond is discounted to $400 (a 60% discount). The $37.50 continues unchanged. The new owner is now getting $37.50 on a $400 investment. $37.50 divided by $400 means he’s earning 9% on his investment.
That bond has gone from paying well below average yield to well above. So that’s a reason to consider this trade.
Secondarily, the bond you’ll be buying is almost certain to be redeemed on time by the U.S. Treasury . . . and at full face value, not what you paid for it. So in addition to the higher interest, you’ll be turning your $400 into $1,000, for a 250% gain. And since the bond has a redemption date, you even know when that happy event will occur.
In a possible scenario like we’ve just discussed, cash is king. The folks with discretionary investment funds might do very well.
Bullet Points:
- Continued low interest rates would mean large bond holders might not have the assets to pay contractual obligations and bonds may have to be sold.
- If interest rates rise to long term averages, the value of existing long term bonds at low interest rates will drop significantly. Their value will be much less than their original purchase price.
- Selling much of the bond portfolio at low prices threatens the viability of the institution.
- But for the subsequent buyer, huge financial gains are possible, if you have the cash to take a position.
Summary: Changing interest rates affect the value of bonds. When rates go up, bond prices go down and vice versa. In periods of low interest rates, the yields on newly purchased bonds may not be enough to meet legal obligations made when rates were higher. To honor these obligations bonds may have to be sold before maturity. For every 1% rise in rates above the bond’s stated interest rate the value of the 30 year Treasury bond (the “long-bond”) declines 20%.
This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional.
Klarise Yahya is a Commercial Mortgage Broker. If you are thinking of refinancing or purchasing five units or more, Klarise Yahya can probably help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected].
If you’ve missed some of the prior articles, basic guidelines on successful investing are in my book “Stairway to Wealth” available at www.LuLu.com