Interest Rates Are Low, Now What? - Adam Watson

COVID-19 has changed much of our lives in 2020.  Many aspects, like masks, are immediately noticed, however some may take longer to appreciate and fully understand.   I’ve been spending a lot of time reading about low interest rates, another consequence of COVID.  This seems to be a daily conversation I’m having with clients who have had GIC’s mature over the summer. 

This is a major concern for investors.  There has been constant chatter of the traditional balanced portfolio of 60% equity and 40% bonds being dead because the bond buffer may no longer provide the required returns for many to reach their goals, and it may not provide the same protection in market downturns either.  This was never more apparent than in March.

The entire world is in this similar situation as they deal with COVID and try to keep economies afloat.  We’ve seen countries around the world cut interest rates to zero as a side effect.  Illustrating this point are current bond yields (returns), provided below, for some developed economies at the beginning of September: 

A couple points on that chart jump out at me.  The first one is that nearly half of the bond returns are negative.  Even the best returning government bond is still below 1%.  In Canada, low rates have now shifted to GIC’s as well.  For most of the summer, a one-year GIC was returning less than 1% and a five-year GIC barely 1.5%.  

A question I am regularly receiving right now is how do we pay for the stimulus that central banks and governments have doled out to dampen the COVID-induced effects on the global economy?  My quick answer has always been a couple ways.  First, expect rates to be lower for longer, along with inflation being allowed to creep a bit higher.  Why would inflation be allowed to creep higher?  Higher inflation allows the government to borrow today but pay back the debt in future dollars, which are effectively worth less because of said inflation.  The other easy answer is to expect higher taxes, which may mean new taxes levied by governments to tap new revenue sources.

One new statistic I hadn’t considered until listening to an Animal Spirits Podcast from Sept 9^th, 2020 was that even though the US government had issued so much additional debt in 2020, with the current lower interest rates, the actual interest carry on the debt is lower than it was in 2019.  Let’s think of that premise using a small world example.  Housing has been very hot this year.  Essentially, this would be similar to selling your house, moving to a larger house and getting a bigger mortgage then you had before, but making the same payment (or a smaller one) because you could get a mortgage at 2% instead of 3.75%. 

This notion has led me to think about Japan, a country that has endured sluggish economic growth and low interest rates for a long time, arguably without much likelihood of moving higher.  For comparison, here is a chart of the 10-year Japanese government bond compared to the 10-year US Treasury: 

As you’ll notice, the Japanese bond has yielded (returned) under 2% since 1996!  Is the rest of the developed world moving down a similar path?  Only time will tell, but it is a major risk to many investors.

The other problem with low interest rates might be more important in long term planning.  Low rates will be a challenge for many pensions around the world, because the majority have a minimum return threshold to remain “sustainable”.  Typically, in Canada, this number has been around 7% Returns of that magnitude were easily obtained in the 70’s, 80’s and early 90’s when bonds were paying higher interest rates (chart below).    

Let’s run a real-life example using Canadian GICs.  If you move your entire portfolio into five-year GICs that are yielding the current 1.5%, what happens next?   First you pay taxes of say 30-50% on the interest income, meaning that your after-tax return is 0.75% to 1.05%.  This is before any inflation is considered. Presently, inflation (as measured by the Bank of Canada) is low.  However, the long-term target is somewhere between 1 to 3% with a targeted goal of 2%. Inflation is tracked by measuring the Consumer Price Index on a basket of commonly used goods.  If you purchase different goods than the standard basket, your household’s inflation could be less than or greater than the headline number.  But let’s go back to the example.  At 1% inflation, your real return on the GIC portfolio, after taxes and inflation are factored in, is effectively 0%.  At 3% inflation, your purchasing power, or real return, is falling by 2% annually. 

Now comes the tricky part.  What are you supposed to do?  There are a few choices, but there isn’t one optimal solution for all.   With 80% of bonds around the world yielding below 1%, and 90% yielding below 4%, the simple choices are to do nothing, and possibly have your purchasing power eroded, or take more risk.

The first risk many bond investors consider is one of two choices.  One being moving your maturity date further into the future, which usually results in a higher yield, and the second being lowering the credit quality of your bonds.  Investing in longer-term bonds means your duration increases.   Simply speaking, duration is how much you can expect the price of a bond (or pool of bonds) to move if interest rates either rise or fall by 1%. For instance, if you hold a bond with a duration of 7 years (similar to many indexes), with a 1% increase in interest rates, you could expect the bond to fall about 7% in price. If you’re only expecting a 2% or 3% yield to maturity, a move of this size would wipe out years of return on your bond.  I’ve spoken with many active bond management teams over the summer and the theme seems to be that duration is increasing across the board as the thought of lower rates for longer becomes more common.  

Decreasing the credit quality of your bond portfolio also has the same duration risk, however it also can have additional credit risk as higher yielding corporate bonds are more susceptible to economic shocks like we saw with COVID in March.  What does that mean?  It means the price of the bond can fall for more reasons than interest rates alone.  Below I’ve attached a chart of the US high yield spread compared to US treasuries, which is the difference in interest rates that higher risk companies pay on their bonds, versus what rate the US government pays on their bonds for a similar term.  Note the big spike earlier this year.  The price of these high yield bonds fell to where they had yields to maturity of nearly 11% more than US treasuries as investors wondered which companies would survive the shutdown.   

 Although US high yield bonds have recovered, their yields are still stuck at elevated levels, comparable to three years ago, as COVID lingers.

Taking more risk with your bond holdings can mean many things.  As discussed above, it could mean moving a portion of your fixed income into longer term bonds; moving into higher yielding (and riskier) corporate bonds; or even moving more of your bond component into the stock market.   Another interesting approach could be moving 5% of your fixed income allocation and 5% of your equity allocation into the ‘alternative’ fixed income space, which can include investments in: market-linked principal-protected notes; private lending, where investor pools provide loans to businesses or individuals; factoring of accounts receivables, where a business sells its receivables at a discount; and bond hedge funds, where fund managers can deploy strategies that attempt to profit from a gain and/or loss in bond prices.  By reducing some equity and fixed income exposure, you lower your stock market risk, but also your duration, or interest rate risk, by investing in a non-correlated asset class.  Most alternative fixed income investments are more complex, come with higher costs and usually less liquidity, so they are not for everybody.  If you have any specific questions about this area, please do not hesitate to contact a member of the JMRD Watson Advisor Team.

Realistically, a combination of those prior choices, in small percentages, could work, depending upon your risk tolerance. There is no right or wrong answer to this question.  It is a very personal decision based upon your unique situation.  But you need to know and be aware of the risk you are taking with your “safe” investments.