Vineer Bhansali Paper

The Return on Your Money or the return of your money

Investing in a World of Negative Rates

Action by global Central banks have recently driven shortterm interest rates and in many cases yields environment, looking at investment as similar to insurance policies or sources of investment return is an intuitive first step. Within this context, we discuss how numerous ingrained principles of financial practice are called into question. The impact of sustained nagative yields is not only important for investors, but also for economic outcomes that emanate from the search for returns versus investment for principal preservation.

There has been considerable historical debate regarding negative interest rates.They range from treating negative rates (and yields) as impossible, to possible but “absurd,” to a possibly permanent fixture of our markets. Compare the following historical quote:

A basic principle of Austrian ecnomics is that the original rat of interest (the rate of dicount of future goods compared to the present, otherwise identical, good) can never be negative.
The reason for this arises not because capital is productive, nor out man’s psychology. Rather, it is embedded in the very concept of human action.(Walter Block, 1978) with the more recent quote:

it may be time[….] to go negative,’if lowering interest rates stimulates the economy and policy rates are already very low or even zero, then why not keep cutting rates and have negative interest rates? The idea of negative rates, that is, lending 100 and getting back say 95, may seem absured but remember this: Early mathematicians thought the idea of a negative number was absurd[too].’ (Benoit Coeure quoting greg Mankiw,2014) with the reality that we are in negative-yielding markets today, the discussion has shifted from theory and opinion to financial consequences.

The Current negative yields are indeed unprecedented in modern finance, and will likely have ongoing investment consequences.

Impact of negative yields on government bond and money markets

The basic building block for the bond markets is the zero coupon bond of an arbitrary maturity. if the zero coupon yield is negative, the discount factor grows with time exponentially. This means that the “discount” for a longer maturity bond in the form of less capital being returned upon maturity is higher than for a shorter-maturity bond, but it is locked in over time and paid up front. This situation is clearly reminiscent of the kind of pricing one would expect from an insuance policy, or a long-dated option strategy. And, indeed, negative-yielding bond markets tend to behave more like insurance policies than as investment assets. This is because, with a negative zero-coupon bond, an investor, like an insurance policy buyer,pays up front for “protection,” in this case a oremium for expected principal return in the form of a return of lessprincipal at the negative rate. We can easily convert the extra price(premium) into a yield equivalent. For instance, if the price of a five-year maturity, zero-coupon is boosted up by 5%, this would imply an almost 100 basis point or 1% “insurance” premium for safety.

Now think of a checking account as a liquidity source: Customers routinely pay for this ligidity via checking account fees.If we think of bond yields as nothing but averages of short-maturity forword checking account, where we are entering a commitment of being able to access liquidity with a perceived “guarantee” (backed by the good faith and credit of the bond issuer, as opposed to, for instance, the FDIC insurance in U.S.), then the “insurance premium” that we are willing to pay in the distant horizon for this liquidity is the negative yield equivalent.And even though it may seem counterintuitive to lock in negative rates for an extended period of time, if investors are looking for certainty in an uncertain environment, they may well want to buy the “insurance”
for longer, since they will not have to renegotiate the “policy” at a futre date at an unknowm price.

Impact of negative yields on equity and credit markets

At their most basic, equity prices are a function of the present value of expected dividends, growth of dividends and any repricing that arises from multiple expansion. If rates fall, dividends will likely move in the same direction (but cannot of course go negative). The simple Gordon equation,

Where D,P,r and g are dividend, price, long-term interest rate and expected growth rate of dividends, explain this.Since the left hand side, dividend (D) divided by price (P), cannot be less than zero, in order for two sides to remain equal, if the long-term interest rate(r) is negative, the expected growth rate of dividends (g) must be equally negative or more negative, which could be interpreted to signal deflation or even future defaults.To further understand the potential impact of negative yields on equities, it is important to understand the impact on the underlying assets of the firm (equities can be thought of as call options on the assets of the firm). If the duration of the assets is expected to be postive, i.e., the impact of rapidly falling rates raises the value of assets, then we should expect all parts of the capital structure (from junior slices like equities, to senior slices like corporates bonds) to increase in value as rates fall. However, after be account for the over all impact of falling rates on the overall assets of the firm, equity typically has negative duration to low rates, whereas the higher parts of the capital structure such as senior corporate bonds tend to have positive duration.Thus the impact of falling yields can have a complex impact on the slices that make up the capital structure of the firm.

Consider the corporate bond floater market, where an issuer pays some floating rate plus a spread in exchange for cash. The implicit understanding is that the lender will not be subject to a negative coupon. However, there is no explicit rule that suggests that the borrower could not demand payment on top of the return of the principal, and if the floating rate(say libor) moves further into negative territory, could the issuer demand additioal payment from the investor as compensation for the lower rate? Might lenders refuse to lend in this perverse environment? Might the borrower hold back some of the principal that he would otherwise have had to pay back? This pricing problem could potentially become a future legal problem.And, for example,on 3 February 2015 the yield on a Nestle corporation bond indeed went negative, so this consideration is not just theoretical.

Impact of negative yields on forign exchange markets
As we move from assets in a single country to money across countries, a number of factors come into play inerest rates are just one.Terms of trade, purchasing power, inflation rates, productivity differentials, etc., are all determinants of exchange rates. However, inerest rates play a critical role because, all else being equal, money will flow from low yielding currencies to high-yielding currencies.If we think of the negative inerest rate as an “insurance premimum” to hold the currency, the more negative the relative interest rate becomes, the more expensive it is to hold that “insurance policy.” Switzerland is an extreme example, since deposit rates became so negative that borrowing in another country to lend in Swiss francs, unhedged, in the short term became aguarantee of negative income. The main reason to enter such a transaction is if it provides a clear benefit (principal preservation) or the potential for capital gains. Indeed, in a currency basis swap the extra swap spread when exchanging currency payments from a low demand currency to a high demand currency is just such a form of compensation for liquidity.
Impact of negative yields on risk measurement
All of this raises the issue of what negative yields means for risk management and other elements of portfolio construction, consider this extensionof an argument taken from Greg Mankiw. Suppose the government declared one day that all currency notes with a randomly picked last digit would cease to be currency. This would immediately make the expected return to holding currency close to -10%. This is the equivalent in expected value to a yield on deposits of -10%.However, faced with the probability of loss on one-tenth of currency in a random fashion, most investors would likely choose to take a deterministic – 10% loss, in part due to the fear of the small but non-negligible risk of losing more than 10% in a fat tail outcome.
So if there were a wav to lock in certainty, most risk-averse inestors would prefer to consider, at a cost, some from of “insurance” rather than a ramdom loss in the future. Given a choice between uncertain or explicit confiscation, a riskaversse investor usually prefers to lose some money for sure rather than gamble. If enough pepole think this way,negative yields could become a more prevalent fixture in financial markets, and risk management systems (stress shocking analytics, etc.) would need to be re-engineered to account for this. In other words, the analytical framwork developed for dealing with efficient markets for investment assets has to be updated when insurance like assets become a large part of portfolios.
Negative yields in major developed markets are now a reality, another cosequence of experimental policies that central banks are employing as they attempt to coax the global economy toword sustainable recovery.In a world with even the possibility of negative yields, classifying investments as similar to insurance policies or sources of expected return is a good first step toward proper portfolio construction.

All investments contain risk and may lose value. This article contains the current opinions of the author, but not necessarily those of PIMCO. Such opinions are subject to change without notice.This article has distributed for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission.


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