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Macro outlook

What do negative interest rates mean for investors?

Bill Martin
Head of Global Fixed Income, Chief Investment Officer
Brian Nick
Chief Investment Strategist
Lovely Mountain Range

With interest rates falling sharply, even more sectors of the global bond market are trading in negative territory. We explain what this means for investors, offer perspective on where markets may be headed and suggest strategies to position portfolios to preserve income and protect against losses.

Highlights 
  • Negative rates are unlikely to afflict the U.S. bond markets directly but rather via higher demand from overseas investors.
  • While a rebound in global growth could push rates higher, we think yields will remain range bound.
  • Even bonds with negative yields can produce returns for investors if held over relatively short periods; active management matters.
  • Investors should expect lower returns across asset classes in the coming years, making selectivity critical.
  • We don’t think this is a time to overreach for yield and suggest broadening portfolio construction to include emerging markets debt and alternatives to generate income. 

Why are $15 trillion of global bonds trading with a negative interest rate?


The variety of forces pushing down global rates have strengthened over the past several months. The latest decline comes from a combination of slow global growth, heightened demand for safe assets and the start of synchronous rate cutting by the world's central banks. Regulatory changes since the global financial crisis have also increased structural demand for highly rated fixed income at virtually any price. Additionally, the long-term moderation in global inflation has lowered the equilibrium rate of interest in most major economies, allowing rates to drift lower, even into negative territory. 

Will interest rates eventually turn negative in the U.S. as they have in other developed countries?


We don’t think so. Interest rates are at least loosely tied to nominal growth, and the U.S. economy consistently produces higher GDP growth and inflation than the eurozone, Switzerland or Japan. The U.S. Treasury is also issuing new debt at a far more rapid clip than these other countries, to the tune of $1 trillion a year or more. To the extent negative-yielding debt is a problem of demand outstripping supply, it is less likely to be an issue when supply is also growing rapidly. All of this said, global interest rates could potentially fall even further should global growth continue to slow or should one or more major economies enter recession.

Are negative interest rates a permanent feature of the fixed income landscape?


“Permanent” is a long time, but we do not expect a meaningful rise in rates in the near or medium term. The markets’ focus on trade-related uncertainty and falling global economic growth seems unlikely to abate anytime soon. And global central banks seem committed to pushing down short-term interest rates all over the world, which will impact longer-term rates as well.1 The downward pressure on rates is both cyclical and secular, meaning even if the global cycle turns up unexpectedly, the structural forces we mentioned previously will still be pushing rates lower for longer.

Does it make sense for investors to own negative-yielding bonds?


In many cases, yes, especially since these bonds have already contributed to returns in 2019. Consider that the Bloomberg Barclays Germany Treasury Bond Index began the year with a -0.1% yield, but has returned over 6% in euros year to date through August 12. Negative yielding bonds may not be attractive for most individual investors if held to maturity, but their prices may still rise over shorter periods, giving them value if used judiciously in diversified portfolios. 

How do negative rates on a large percentage of high quality bonds affect other markets?


All else equal, when interest rates fall, forward-looking bond returns decline and other types of assets such as lower-rated corporate credit or equities may become somewhat more attractive. We have seen a widening of risk premiums in recent months, even with many global equity indexes at or near all-time highs. Corporate bond spreads typically widen initially as rates fall on growth concerns, but the high demand for yield has typically supported credit markets in the aftermath, forcing spreads to compress once again.

Negative interest rates signal too little risk appetite among investors. One reason central banks reduce interest rates in times of low growth or during periods of turmoil is to incentivize investors to prefer other types of assets to government bonds or cash. At the same time, however, low interest rates themselves can be harmful to the operating models of banks and other financial institutions, negatively affecting the economy and equity markets.

What do negative yields mean for portfolios?


The main takeaway for us is that the growth of negative-yielding bonds reinforces our belief that returns are likely to be lower over the next 10 years compared to the past 10. Starting with a look at bonds: Bond returns are driven by varying degrees of three factors, depending on the sector: expected income, price return driven by changes in rates and price returns driven by changes in credit spreads. The longer an investor’s time horizon, the more the expected income determines total return rather than short-term price fluctuations. While it may be counterintuitive, a long-term investor may actually benefit when rates rise over time, which translates to higher expected income levels. A forecast of “lower for longer” rates may translate to lower long-term expected returns.

Equity returns are driven by a similar set of factors: expected dividend income, price return driven by earnings growth and price return driven by valuation changes. To the extent that negative yields indicate slowing economic growth and diminished risk appetite, this may continue to weigh on earnings growth. Valuations are also elevated versus historic standards, indicating investors may want to temper their equity return expectations as well.

Regarding our near-term, tactical views, lower-for-longer yields means investors should be wary of cutting duration exposure. While a flatter yield curve means there is less yield compensation for extending duration, most invest in bonds within the context of an outcome-focused portfolio rather than to outperform a fixed income benchmark. Duration exposure can be a key diversifier versus other parts of a portfolio (such as equities, corporate credit and real estate), particularly during times of market volatility.

What do these lower expected returns mean for strategic allocations?


We suggest three approaches:
  1. Focus on the long term: It’s an opportune time to review long-term goals and short-term risk objectives. Review your strategic asset allocation versus up-to-date capital market assumptions, to see if the expected return and risk are still appropriate. We know from previous market cycles that some investors understand their true risk tolerance only after a severe market downturn, so now is a good time to confirm long-term goals and short-term risk objectives while reviewing strategic asset allocation decisions. 
  2. Don’t take on too much risk by overreaching for yield: While we don’t believe a recession is imminent, we think investors should consider shifting toward higher quality, growth-oriented equities and investment grade bonds (despite potentially lower yields compared to their value and high yield counterparts).
  3. Consider broadening asset class exposures for further diversification: Emerging market debt may offer the opportunity to invest in fast-growing economies where, unlike most in the developed world, the demand for capital (relative to the supply) is still high. The sector has offered reasonable yields (4.9%) compared to developed market debt (2.2%), as well as improving credit fundamentals and limited inflationary pressures in select areas.2 Given the diverse opportunity set, active management in this space in critical.

Alternative asset classes are also worth consideration, particularly core real estate. In our experience, because many of these asset classes are, by their nature, long-term, buy-and-hold investments, they may be less volatile on a day-to-day basis than publicly traded equities. As such, they have the potential to offer valuable diversification and stability benefits for a broader portfolio.

Finally, evaluating an overall portfolio through an environmental, social and governance (ESG) lens may act as a quality overlay and potentially reduce downside risk. This exercise can also help investors understand the risks associated with long-term ESG trends.
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Endnotes
1 Source: “The Fed is leading a global push to lower rates, and Europe is getting ready to follow suit,” CNBC.com, 24 Jul 2019.
2 Source: Bloomberg, L.P. Bloomberg Barclays Emerging Markets USD Aggregate Index and the Bloomberg Barclays Global Aggregate Index, as of 12 Aug 2019.

Sources

Economic and market data from Bloomberg

This material is provided for informational or educational purposes only and does not constitute a solicitation of any securities in any jurisdiction in which such solicitation is unlawful or to any person to whom it is unlawful. Moreover, it neither constitutes an offer to enter into an investment agreement with the recipient of this document nor an invitation to respond to it by making an offer to enter into an investment agreement. 

This material may contain “forward-looking” information that is not purely historical in nature. Such information may include projections, forecasts, estimates of yields or returns, and proposed or expected portfolio composition. Moreover, certain historical performance information of other investment vehicles or composite accounts managed by Nuveen may be included in this material and such performance information is presented by way of example only. No representation is made that the performance presented will be achieved, or that every assumption made in achieving, calculating or presenting either the forward-looking information or the historical performance information herein has been considered or stated in preparing this material. Any changes to assumptions that may have been made in preparing this material could have a material impact on the investment returns that are presented herein by way of example.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by Nuveen to be reliable, and not necessarily all-inclusive and are not guaranteed as to accuracy. There is no guarantee that any forecasts made will come to pass. Company name is only for explanatory purposes and does not constitute as investment advice and is subject to change. Any investments named within this material may not necessarily be held in any funds/accounts managed by Nuveen. Reliance upon information in this material is at the sole discretion of the reader. Views of the author may not necessarily reflect the view s of Nuveen as a whole or any part thereof. 

Past performance is not a guide to future performance. Investment involves risk, including loss of principal. The value of investments and the income from them can fall as well as rise and is not guaranteed. Changes in the rates of exchange between currencies may cause the value of investments to fluctuate.

This information does not constitute investment research as defined under MiFID. 
 
Glossary

The Bloomberg Barclays Emerging Markets USD Aggregate Bond Index is a flagship hard currency emerging markets debt benchmark that includes fixed and floating-rate U.S. dollar-denominated debt issued from sovereign, quasi-sovereign and corporate emerging markets issuers. The Bloomberg Barclays Germany Treasury Bond Index measures the performance of fixed-rate nominal debt issued by the German government. The Bloomberg Barclays Global Aggregate Bond Index is a flagship measure of global investment grade debt from twenty-four local currency markets. This multi-currency benchmark includes treasury, government related, corporate and securitised fixed-rate bonds from both developed and emerging markets issuers.

A word on risk

This report is for informational and educational purposes only and is not intended to be relied upon as investment advice or recommendations, does not constitute a solicitation to buy or sell securities and should not be considered specific legal, investment or tax advice or analysis. The analysis contained herein is based on the data available at the time of publication and the opinions of Nuveen Research. The report should not be regarded by the recipients as a substitute for the exercise of their own judgment. All investments carry a certain degree of risk, including possible loss of principal, and there is no assurance that an investment will provide positive performance over any period of time. Past performance is no guarantee of future results.

Equity investments are subject to market risk or the risk that stocks will decline in response to such factors as adverse company news or industry developments or a general economic decline. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, tax risk, political and economic risk, and income risk. As interest rates rise, bond prices fall. Below investment grade or high yield debt securities are subject to liquidity risk and heightened credit risk. Non-U.S. investments involve risks such as currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. These risks are magnified in emerging markets.

Alternative investments may be illiquid, there may be no liquid secondary market or ready purchasers for such securities, they may not be required to provide periodic pricing or valuation information to investors, there may be delays in distributing tax information to investors, they are not subject to the same regulatory requirements as other types of pooled investment vehicles, and they may be subject to high fees and expenses, which will reduce profits. Alternative investments are not suitable for all investors and should not constitute an entire investment program. Investors may lose all or substantially all of the capital invested. Real estate investments are subject to various risks, including fluctuations in property values, higher expenses or lower income than expected, currency movement risks and potential environmental problems and liabilities. ESG will include only holdings deemed consistent with the applicable Environmental Social Governance (ESG) guidelines. As a result, the universe of investments available will be more limited than other portfolios that do not apply such guidelines. ESG criteria risk is the risk that because the ESG criteria exclude securities of certain issuers for non financial reasons, a portfolio may forgo some market opportunities available to others that don’t use these criteria. 

Nuveen provides investment advisory solutions through its investment specialists.