The Cost of Safety in the Bond Market

Fear helps us make choices, quickly. Without fear, the stock market would always go up and we would have no need to look for safe alternatives. If we are always making choices between growth, income, and preservation, then what do our investment options look like here in the Summer of 2019? The truth is, our options for safety and income have become more complex, and anyone invested in the bond market should be aware of what has changed.

There is an investing trend emerging throughout the world, and it is changing the way we think about how we are compensated for risk. Stocks did what they sometimes do last week and in an uncertain world we understand that. I would like to focus on something different: Your safe money. Specifically, how much are you being paid to keep it protected?

Bond Market Update

If you put your money in a savings account, a CD, or a bond you expect to be paid interest, sometimes paltry, for the use of your money. You also expect to get that money back at the end of a term. The longer you put it away, and the riskier the institution to which it is lent, the more interest you should earn. What if instead of being compensated less for safety, you had to pay interest to get your money back? That’s happening around the world right now. It is the phenomenon of negative interest rates and while it used to be unheard of it is now creeping across Europe and Asia. Over $15 trillion in bonds around the world now have negative rates.

Last week, German bonds maturing from one year to 30 years had negative interest rates.  This meant that you could lend the German government your money for ten years, but you would have to pay .5% or more per year to get your money back. It’s a crazy development, born of years of attempted stimulus for Europe’s economy and the high demand for safety from investors (higher demand for bonds means lower yields). This means people are willing to accept lower returns on their safe money and pay for that safety out of fear that conditions will get worse.

Interest rates in the U.S. have dropped substantially in the last twelve months based on some of the same fears, but rates are still positive.  It is not inconceivable that we could see negative rates. But there are implications to extreme low rates even if they never dip below zero.

Implications of Negative Rates

  • Low and negative interest rates change our calculations for investment returns. One year ago, if you needed 5% annual returns to meet your goals, Treasury bonds were contributing 3% to that total, which was an improvement over years past. Now, that number for ten-year Treasury bonds is down below 2%. That means your other assets need to work harder to make up the difference. If you own bonds or cash, this is not a bad time for a sanity check on what your return expectations should be.
  • Low rates make us look elsewhere to get either returns or safety. If we still want income we can look at lower quality bonds or higher divided stocks, as long as we understand the risks of both. If we want safety, it is a bit more challenging. The desire for protection can be a result of our fears about the market, but it’s a bad idea to make investment decisions based on fear. Have a conversation with your advisor about “safety from what?” Market risk, income, inflation. Each one is different and the solution will be unique to you.
  • Beware of comparing bond funds by the interest that they pay. For years after the Financial Crisis I heard investors say that they just wanted a “safe 5%” like they had in 2007, as if that was something that still existed in 2012. You get paid less for safety in times like this so your bond fund that is still paying a higher than market rate might be taking some pretty unsavory risks. Look at more than just interest rates when you choose between bond fund options.
  • Treat your emergency reserves differently from your intermediate and long-term investments. It can be tempting to try and juice the income on your savings by chasing yield, but be careful. It may get harder to find savings and money market accounts that pay much.  You should know how much money you need to set aside for the short term and don’t sacrifice the safety of that principal for the uncertainty of higher income.

We try to make choices with the best information available. Choosing wisely is tough when we talk about negative rates in the bond market because it is something we have never seen to this extent. Central banks and politicians will continue to wrestle with how to drive economic growth, but for now we as investors need to know that the cost of safety has gone up. The options are different than they were just a few months ago. You should be talking with your advisor about how those changes affect your plan and whether now is the time to adjust expectations or make investment changes.